PLEASE UPLOAD ANSWER IN COMPUTER FORMAT ONLY 12/7/12 Chapter: 9 Problem: 18 INPU

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PLEASE UPLOAD ANSWER IN COMPUTER FORMAT ONLY

12/7/12 Chapter: 9 Problem: 18 INPUTS USED IN THE MODEL P0 $45.00 Net Ppf $28.00 Dpf $3.25 D0 $2.20 g 6% B-T rd 9% Skye's beta 1.05 Market risk premium, RPM 5.5% Risk free rate, rRF 5.5% Target capital structure from debt 40% Target capital structure from preferred stock 5% Target capital structure from common stock 55% Tax rate 35% Flotation cost for common 10% a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the DCF method and the CAPM method to find the cost of equity. Cost of debt:        B-T rd           ×          (1 – T)      = A-T rd Cost of preferred stock (including flotation costs):           Dpf             /           Net Ppf       = rpf Cost of common equity, DCF (ignoring flotation costs):             D1           /            P0             +              g          = rs Cost of common equity, CAPM: rRF   + b   × RPM   = rs = IMPORTANT NOTE: THE CAPM AND THE DCF METHODS MAY PRODUCE A VERY SIMILAR COST OF EQUITY. b. Calculate the cost of new stock using the DCF model.       D0 × (1 + g)     /        P0 × (1 – F)       +              g          = re c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the DCF method and add that differential to the CAPM value for rs.) rs + Differential = re        + = Again, we would not normally find that the CAPM and DCF methods yield identical results. d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company's WACC? wd 40.0% wpf 5.0% ws 55.0% 100.0%      wd × A-T rd    +        wpf × rpf     +         ws × rs        = WACC = e. Suppose Gao is evaluating three projects with the following characteristics:      (1) Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred             stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for             the project. All equity will come from reinvested earnings.      (2) Equity invested in Project A would have a beta of 0.5. The project has an expected return of 9.0%.      (3) Equity invested in Project B would have a beta of 1.0. The project has an expected return of 10.0%.        (4) Equity invested in Project C would have a beta of 2.0. The project has an expected return of 11.0%.      Analyze the company’s situation and explain why each project should be accepted or rejected. Beta rs rps rd(1 – T) WACC Expected return on project Accept? (Yes or No) Project A 0.5 Project B 1.0 Project C 2.0

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INPUTS USED IN THE SPREADSHEET P0, the price of common stock $45.00 Net Ppf, the price of preferred net of flotation costs $28.00 Dpf, the dividend on preferred $3.25 D0, the most recent common stock dividend $2.20 g the growth rate 6% rd, before-tax required return on debt 9% b, the firm's beta 1.05 MRP, Market risk premium 5.5% rRF, Risk free rate 5.5% Target capital structure from debt 40% Target capital structure from preferred stock 5% Target capital structure from common stock 55% Tax rate 35% Flotation cost for common 10% OUTPUT SECTION OF SPREADSHEET a. Calculate the cost of each capital component, i.e., the after-tax cost of debt, the cost of preferred stock (including      flotation costs), the cost of common equity (ignoring flotation costs) with the DCF method and the CAPM method. Cost of debt (after-tax) 5.9% Cost of preferred stock (including flotation costs) 11.6% Cost of common equity, DCF (ignoring flotation costs) 11.18% Cost of common equity, CAPM (ignoring flotation costs) 11.28% b. Calculate the cost of new common stock, (i.e. including flotation costs) using the DCF model. 11.76% c. Using the target capital structure and assuming that it will not issue new equity,       what is the WACC? 9.1% d. Using the target capital structure, what is the weighted average cost of capital when using new equity?        9.4%

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