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

Answer : 1) Required Return on stock : Risk free rate + beta (Market Premium)

= 3% + 1.2(5%)

=3%+6%

= 9%

2) P0 = D1/(Expected return - growth)

60 = 3(1.06)/ (x - 0.06)

60 = 3.18/ (x - 0.06)

(x - 0.06) = 3.18/60

x = 0.053+0.06

x = 11.6%

3) Yeild to Maturity of bond = (Coupon Payment + ((face value - purchase price )/ number of years )) / (FV + PP)/2

= (90+((1000-1100)/13)) / ((1000+1100)/2)

= 7.8% approx

answer is C 7.75%

4) market Value of equity = 10,000,000 * 60

= 600,000,000

Market value of debt = 500,000*1100

= 550,000,000

Share of equity in market value = 600,000,000 / 1150,000,000

= 52.17% or 52% approx

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