Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common sharehold
ID: 2740270 • Letter: R
Question
Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common shareholders’ equity at book value of $8,000. The market value of its common stock is $12,000 and the market value of its debt is the same as that on the balance sheet ($4,000). ROC's current market equity beta is 1.5. The risk-free rate in the economy is 3.5% and the market risk-reimium is 7%.
The firm faces 40% marginal tax rate. You are planning to to buy the firm with 50 percent common equity and 50 percent debt carrying an interest rate of 12 percent (the same as its current interest rate cost). Your forecasted free cash flow to both debt and equity stakeholders are given below. The free cash flows are expected to grow 4 percent annually forever after Year 5.
What is ROC's new cost of common equity at your proposed capital structure?
17.5%
14.0%
10.5%
7.0%
Year Free Cash Flow to Debt & Equity holders 1 $1,200 2 $1,560 3 $1,700 4 $1,980 5 $2,100Explanation / Answer
Answer:
ROC’s new cost of common equity by using Capital Asset Pricing Method. The formula for required rate of return is :
Rr = Risk free return + Beta (Market Risk Premium)
= 3.5% + 1.5 (7) = 14%
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