Problem
I. The Rollag Co. just issued a dividend of $2.75 per share on its common stock. The company is expected to maintain a constant 5.8% growth rate in its dividends indefinitely. If the stock sells for $59 a share, what is thecompany's cost of equity?
II. Suppose Whitney Ltd. just issued a dividend of $2.08 per share on its common stock. The company paid dividends of $1.71, $1.82, $1.93, and $1.99 per share in the last four years. If the stock currently sells for $45, what is your best estimate of the company's cost of equity capital using the arithmetic average growth rate in dividends? What if you use the geometric average growth rate?
III. Pearce's Cricket Farm issued a 30-year, 7% semiannual bond 3 years ago. The bond currently sells for 93% of its face value. The company's tax rate is 35%. Assume the par value of the bond is $1,000.
i. What is the pre-tax cost of debt?
ii. What is the after-tax cost of debt?
iii. Which is more relevant, the pre-tax or the after-tax cost of debt? Why?
IV. Peacock Corporation has a target capital structure of 70%common stock, 5% preferred stock, and 25% debt. Its cost of equity is 11%, the cost of preferred stock is 5%, and the cost of debt is 7%. The relevant tax rate is 35%.
i. What is Peacock's WACC?
ii. The company president has approached you about Peacock's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?
V. Suppose your company needs $24 million to build a new assembly line. Your target debt-equity ratio is .60. The flotation cost for new equity is 7%, but the flotation cost for debt is only 3%. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.
i. What do you think about the rationale behind borrowing the entire amount?
ii. What is your company's weighted average flotation cost, assuming all equity is raised externally?
iii. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?