Problem
The Reef Corporation has an opportunity to sell shark repellant. Oscar, the CEO, would like Sykes, the vice president, to evaluate the project. Oscar owns all 50,000 outstanding shares of the Reef Corporation. Oscar plans to receive $1.3 in dividends at the end of the year. Oscar plans to grow the dividends at 8% a year. Frankie, an independent financial analyst, has estimated that the bonds should sell for $1075. Frankie has estimated that the stock should sell for $17.75. Frankie has estimated the beta to be 1.25. Frankie estimates the market will return 11%. Lino, the godfather, will have an antidote to the repellant after five years. Don Feinberg owns all 600 outstanding bonds. Don Feinberg receives $35 interest payments every six months. Lenny, the operations manager, has estimated that they will need 5 pieces of equipment that cost $200,000 each. Installation will be a flat $90,000. Lenny estimated that they will need $155,000 more in inventory. Lenny believes that the equipment will be worth $355,000 after the five-year run. Lenny has estimated the cost will be 28¢ per unit. Lenny estimates that fixed cost will be $30,000. Lola, the marking manager, believes the repellant will sell for $1. Lola believes the demand will be able to sell 350,000 in year1; 450,000 in year 2; 600,000 in year 3; 550,000 in year 4; and 450,000 in year 5. Angie, the CFO, says the equipment will fall under a 5-year MACRS. Angie estimates that accounts payable will increase by $60,000 and accounts receivables will increase by $50,000. Angie has estimated the tax rate as a flat 40%. The Reef Corporation bonds mature in 12 years. The par value on the bonds is $1000. The coupon rate is 7% on the bonds. Treasury bonds yield 4%. The bond risk premium is 6%.
a) What is the cost of equity using the security market line equation?
b) What is the capital gains yield?