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What is the cost of equity

Intermediate Finance

 

Always leave 4 decimals in the ($) numbers in your calculations (e.g. PMT = $10.8924) and, particularly, 6 decimals for interest rates (e.g. r = 0.078643 or 7.8643%).

QUESTION 1:?Conlins Manufacturing is considering building a new plant to manufacture washing machines on the land it bought 20 years ago for $2,000,000. The land is currently appraised at $10,000,000. The construction cost of the plant will be $20,000,000. The following market data on Conlins Manufacturing securities are current:

Common Stock: Debt:

Preferred Stock:

Market:?An initial investment of $10,000,000 in net working capital is required. Tax rate is 40%.?a. Determine the weighted average cost of capital.?b. The plant will have 20 year useful life. It will be depreciated straight line, and after 20 years

will be scrapped for $1,000,000. Land is expected to be sold for $20,000,000. Conlins will make 40,000 washing machines per year, and sell them at an average price of $1,000 each. The variable cost will be $500 per washing machine. The fixed cost will be $10,000,000 per year. Determine NPV.

QUESTION 2:?SeasonsDrive Limited (SDL) an all equity firm has 100,000 shares outstanding. Investors currently require 10% return on SDL common stock. The company pays out all earnings as dividends. The company expects to have EBIT of $500,000 per year forever. Assume no personal or corporate taxes.

a. What is the value of the firm? ?SDL would like to replace half of the equity with debt at an interest rate of 6%. 1. What will the new value of the firm be??2. What will the new value of the debt be??3. What will the new value of equity be? ?4. What will the new required rate of return on equity be? ?5. What will the new overall required rate of return on the firm be?

b.                Suppose the corporate tax rate is 40%.

1.                        Using M&M determine the value of the firm, value of the debt, and the value of the equity?

2.                        Does the presence of the taxes increase or decrease the value of the firm? Why?

c. Suppose personal tax rate on debt income is 40% while on the equity income is zero. ?1. What happens to the value of the firm in an MM world with personal taxes? 2. What will happen to the value of the firm as the personal tax rate on interest ?income rises?

QUESTION 3:?ABC Inc. and XYZ Ltd are identical firms in all respects except for their capital structure. ABC is all equity financed with $20,000,000 in stock. XYZ uses both stock and perpetual debt Its Debt/Equity ratio is 2/3 and cost of debt is 6%. Both firms expect EBIT to be $3,000,000. Ignore taxes.

a. Andy Garcia owns $30,000 worth of ABC's stock. What cash flow and the rate of return is ?he expecting?

b.                Show how he could generate exactly the same cash flows and the rate of return by investing ?in XYZ and using homemade unleverage.

c. What is the cost of equity for ABC? for XYZ?

d.                What is the rWACC for ABC? for XYZ? What is your conclusion?

5,000,000 shares, selling for $30 per share; the beta is 1.5. 200,000 5% annual coupon bonds, 10 years to maturity, selling for $926.40 each.?500,000 shares of 4% preferred stock outstanding, selling for $80 per share. Par value is $100 each.

4% expected market risk premium; 2% risk free rate.

-4-

QUESTION 4:

a. XYZ Corp, an all equity firm expects EBIT = $200,000 one year from today, after that it ?expects EBIT to increase at 2% per year forever. Its corporate tax rate is 40% and cost of equity =10%.?XYZ is considering replacing some of the equity with debt. If it becomes levered and there are only corporate taxes, it expects its value to increase to $1,900,000. If there are personal taxes also and personal tax rate on debt income is twice as much as the personal tax rate on equity income, then it expects its value to go up to $1,644,444. Determine B, TB, and TS.

b.                ABC Inc. an all equity firm which has a market value of $5,000,000, expects EBIT of $750,000 per year in perpetuity. Its corporate tax rate is 40%.?The firm is considering replacing some of the equity with a perpetual debt. Suppose cost of debt = 5% and weighted average cost of capital = 7.5%. Determine the cost of levered equity.

c. Supposeσ=24.48,ρ 0.85,σ= 6 = AM AM M Determine σA

 

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