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 = (Expected Dividend / Price ) + Growth rate

= (3*106% / 60) + 6%

= (3.18/ 60) + 6%

= 5.3% + 6%

= 11.3%

Answer-2:

Expected return = Risk free rate + Beta * market risk premium

= 3% + 1.2*5%

= 9%

Answer-3:

Yield to maturity = 2* ((C + (F-P)/n) / ((F+P)/2))

C= Semiannual interest payment = 1000*9%/2 = 45

F = Face value = $1000

P = Price = $1100

n = Number of semiannual = 13 years * 2 = 26

Yield to maturity = 2* ((45 + (1000-1100)/26) / ((1000+1100)/2))

= 2* (45 - 3.8462) / 1050

= 0.0784

= 7.84 %

Answer-

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