A corporation has 10,000,000 shares of stock outstanding at a price of $60 per s

Question

A corporation has 10,000,000 shares of stock outstanding at a price of $60 per share. They just paid a dividend of $3 and the dividend is expected to grow by 6% per year forever. The stock has a beta of 1.2, the current risk free rate is 3%, and the market risk premium is 5%. The corporation also has 500,000 bonds outstanding with a price of $1,100 per bond. The bond has a coupon rate of 9% with semiannual interest payments, a face value of $1,000, and 13 years to go until maturity. The company plans on paying off their debt until they reach their target debt ratio of 30%. They expect their cost of debt to be 6% and their cost of equity to be 9% under this new capital structure. The tax rate is 40%

1. What is the required return on the corporation’s stock? a) 9% b) 10.6% c) 11.3% d) 12.2%

2. What is the expected return on the corporation’s stock? a) 9% b) 10.6% c) 11.3% d) 12.2%

3. What is the yield to maturity on the company’s debt? a) 7.25% b) 7.75% c) 8.25% d) 8.75%

4. What percent of their current market value capital structure is made up of equity? a) 35% b) 42% c) 52% d) 60%

5. What is their WACC using their target capital structure and expected costs of debt and equity? a) 7.4% b) 8.5% c) 9.1% d) 9.8%

6. Given the new cost of debt, what should be the new price of the bond? a) $920 b) $1,060 c) $1,172 d) $1,268

7. Given the new cost of equity, what should be the new price of the stock? a) $71 b) $82 c) 91 d) $106

Explanation / Answer

1.

CAPM required return = Risk free rate + Beta * market risk premium

= 3% + 1.2 *5% = 9%. Therefore, option a) 9% is correct.

2.

Expected return   = (Expected Dividend / Market Price ) + Growth rate

Expected Dividend = Current dividend * (1+ growth rate )

= $3*(1+0.06) = $3.18

= [3.18 / $60] + 0.06

= 0.113 = 11.3%. Therefore, option c) 11.3% is correct.

3.

Relevant yield on the company's debt = YTM

YTM = {C + (F-P)/n} / {(F+P)/2}

C = interest payment = $1000*9%*6/12 =$45

F = Face value = $1000

P = Price = $1100

n= Years to maturity = 13 years * 2 = 26 Semiannual

Hence YTM = {45 + (1100-1000)/26} / {(1000+1100)/2}

= (45 + 3.846) / (1050)

= 0.04652 = 4.65%

Annual yield   = 0.0465 * 2 = 0.093 = 9.3%

5.

Expected WACC = Cost of debt(1- Tax) * Weight of debt + Cost of equity * Weight of equity

= 6(1-0.40) * 0.30 + 9*0.70 = 7.38%

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