1. The corporate treasurer of Gonic Manufacturing Company expects the company to grow at 4% in the future. She notes that debt will have an interest rate of 4% interest and the corporate tax rate is 35%. She believes that debt will be a cheaper option to finance the growth. The current market price per share of its common stock is $19, and the expected dividend in one year is $0.75 per share. Calculate the cost of the company's retained earnings and check if the treasurer's assumption is correct.
2a. The risk-free rate on 30 year U.S. Treasury bonds is 2.75% and the expected rate of return on the overall stock market is 7%. The BOW company has a beta of 1.4. What is the cost of equity?
2b. Les argues that the 10 year note is a better risk free rate at 2%. He also argues that the stock market is too high and the expected return is really only 5%. Assume that he is correct. The company has a beta of 1.4. What is the cost of equity?
3. A company, East Berwick Enterprises, has a capital structure as follows:
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Total Capital
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$1,000,000
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Debt
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$400,000
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Preferred Stock
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$100,000
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Common Equity
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$500,000
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What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital? Assume the applicable tax rate is 40%, interest on debt is 5%, flotation cost per share of preferred stock is $0.75, and flotation cost per share of common stock is $4. The preferred and common stocks are selling in the market for $24 and $130 a share respectively, and they are expected to pay a dividend of $1.50 and $4.50, respectively, in one year. The company's dividends are expected to grow at 5% per year. The firm would like to maintain the existing capital structure to finance the new project.