1- -! t'e Capital Asset 0ricing MGT2016et'o) Financial Approac' Management is appropriateA compute t'e re2uire) rate o! return !

or eac' o! !ollowing Solved by stoc (vuZs s. Assume Solution a ris Team) !ree rate o! $.$B an) e&pecte) return !or t'e mar et port!olio $.12. /6ar s71$1 Zubair o! Hussain <zubair254@gmail.com> tt!"##grou!s$google$com#grou!#vuZs 9toc A B C ( 5 Beta 2.$ 1.5 1.$ $.C $.2 #e2uire $.$B>/$.12- $.$B>/$.12- 7$.$B>/$.12- 7$.$B>/$.12- 7$.$B>/$.121- Company ABC wants to issue$.$B1D1.5 more common $.$B1D1 stoc !ace "alue #s.1$. %e&t year t'e ) rate o! $.$B1D2 $.$B1D.C $.$B1D.2 (i"i)en) is e&pecte) to be #s.2 per s'are assuming a (i"i)en) growt' rate o! 1$*pa. return 7 +'e lawyers, !ee7 an) stoc bro er7commission will cost #s.1 per s'are. -n"estors are ris !ree 15* 1@.5* 12* 7 11.1$* 7B..* con!i)ent about rate o! company ABC so t'e common s'are is !loate) at mar et price o! #s.1. /i.e. 0remium o! #s..1. -! t'e capital structure o! company ABC is entering common return > e2uity t'en w'at /mar et is t'e company %&'' 3 4se #etaine) 5arning Approac' to calculate t'e result. ris /6ar - ris s751 !ree rate or return 1 D beta Calculate #8# !or Common 9toc using :or)on,s ;ormula #!#e2uire) > /#mr 7 /(-<1=0o1 #!1DB > g #m 7 . 0o 7 mar 12 et price 7 1. #! 7 .$B (i"1 7 %e&t (i"i)en) 7 2 : 7 growt' rate 7 1$* 1- (ongstreet 'omm unication )nc$((')) 'as t'e !ollowing capital structure w'ic' is r 7 /2=1.1>1$* 7 22.5$* consi)er to be optimal. (ebt 0re!erre) 9toc Common 9toc Total 'a!ital 25* 15* .$* 100* %ow -! company wante) to issue t'e stoc "ia new !loat t'en it 'as to pay t'e lawyer !ee an) bro er commission w'ic' 1 #s. EC-,s net income e&pecte) t'is year is F1CA142.G.A its establis'e) )i"i)en) payout ratio is @$*A its ta& ratio is 4$*A an) in"estor e&pect earning an) )i"i)en) to grow at a constant %et 1. ? 1 7 EC15 pai) a )i"i)en) o! F@..$ per s'are last year/( 1 an) its stoc rate procee) o! B* in 7 t'e !uture. $ currently sells at a price o! F.$ per s'are. +reasury Bon) yiel) 11* an) a"erage 'as a r 7 /2=151>1$* 7 22.5$* 7 2@.@@* 14* e&pecte) rate o! return an) EC- beta is 1.51. +'e !ollowing terms apply to new security o!!ering. 'ommon" %ew common stoc woul) 'a"e !loatation cost o! 1$*. +re,erred" %ew pre!erre) stoc coul) be sol) to t'e public at price o! F1$$ per s'areA wit' a )i"i)en) o! F11.

-ebt" (ebt coul) be sol) at interest rate o! 12*.

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(&)- ;in) t'e Component Cost o! (ebtA 0re!erre) 9toc A #etaine) 5arning an) %ew Common 9toc 3 /6ar s7C1 EC-,s net income e&pecte) t'is year is F1CA142.G.A its establis'e) )i"i)en) payout ratio is @$*A its ta& ratio is 4$*A an) in"estor e&pect earning an) )i"i)en) to grow at a constant rate o! B* in t'e !uture. EC- pai) a )i"i)en) o! F@..$ per s'are last year/( $ 1 an) its stoc currently sells at a price o! F.$ per s'are. +reasury Bon) yiel) 11* an) a"erage 'as a 14* e&pecte) rate o! return an) EC- beta is 1.51. +'e !ollowing terms apply to new security o!!ering. 'ommon" %ew common stoc woul) 'a"e !loatation cost o! 1$*. +re,erred" %ew pre!erre) stoc coul) be sol) to t'e public at price o! F1$$ per s'areA wit' a )i"i)en) o! F11. -ebt" (ebt coul) be sol) at interest rate o! 12*.

(&)- ;in) t'e Component Cost o! (ebtA 0re!erre) 9toc A #etaine) 5arning an) %ew Common 9toc 3 /6ar s7C1
'ost o, -ebt

+ 7 4$* +a& #ate #) 7 12* interest #ate o! )ebt A!ter-ta& cost o! )ebtH #)/1 - +1 7 12*/1 - $.4$1 7 12*/$..$1 7 C.2$*. 'ost o, !re,erred stoc." (i" 7 11 0rice 7 1$$ Ips 7 (i"=price o! s'are Ips 7 11=1$$ 7 11*

'ost o, retained earnings (using '&+M met od) #e 7 #! > /#m-r!1 D beta 7 11* > /14* - 11*11.51 7 15.5*. 'ost o, ne/ com mon stoc. ; 7 .1$ !lotation cost (o 7 @..$ last year )i"i)en) 0o 7 .$ ? . 7 54 0rice o! s'are. A!ter !lotation cost :7 B* growt' rate (i"1 7 %e&t year )i"i)en) we can get it by t'is !ormula 7 (o/1>g1
Ie 7 /(i"1= 0o1> g Ie 7 /(o/1>g1=0o1>g By a))ing "alues in !ormula Ie7 /@..$/1>.$B1=541>.$B 7 1..2.*

(0)- Jow muc' new capital coul) be raise) be!ore EC- must sell new e2uity3 /6ar s7@1

Company ABC issues a 2 Kear Bon) o! 0ar <alue #s 1$$$ an) a Coupon #ate o! 1$* pa /an) annual coupon payments1. Company ABC pays an -n"estment Ban #s 5$ per Bon) to structure an) mar et t'e bon). +'ey )eci)e to sell t'e Bon) !or #s B5$ /i.e. At a (iscount1. At t'e en) o! t'e !irst yearA Company ABC,s -ncome 9tatement s'ows t'e Coupon -nterest pai) to Bon)'ol)ers as an e&pense. -nterest represents a +a& 9a"ing or 9'iel). Base) on t'e %et -ncome an) -n)ustry 9tan)ar)A t'e 6arginal Corporate +a& #ate is @$* o! %et -ncome. Assuming t'at t'e 2 Kear Bon) represents t'e 8%EK !orm o! CapitalA calculate t'e A!ter-+a& Leig'te) A"erage Cost o! Capital /LACC1 * !or

Solution

Calculate #e2uire) #8# using Bon) 0ricing or 0< ;ormula 0< 7 1$$= /1>rD1 >1$$= /1>rD1 M2 >1$$$= /1>rD1M2 7 1$$= /1>rD1 > 11$$= /1>rD1M 2 7 %et 0rocee)s 7 %0 7 6ar et 0rice -+ransaction Costs 7 B5$ - 5$ 7 #s B$$ 7 1$$=/1>rD1> /1$$=/1>rD1M21> /1$$$=/1>rD1M21- B$$ 9ol"e t'e Nua)ratic 52uation !or 0re-+a& #e2uire) #8# 7 rD 4sing t'e Nua)ratic ;ormulaH rD 7 1.* A%( r 7 - 5 *

Calculate A!ter +a& Cost o! (ebt r( 7 r(D / 1 - +C 1 + 7 @$* 7 1.*/1-.@$1 7 11.2$*

Calculate Leig'te) Cost o! Capital /LACC1 LACC 7 r( O(. > r0 O0 > r5 O5 . 7 r( O( > $ > $ 7 11.2 /11 7 11.2 *

;in) t'e Beta on a stoc gi"en t'at its e&pecte) #eturn is 1.* t'e #is !ree rate is 4* an) t'e 5&pecte) return on t'e 6ar et port!olio is 12* /6ar s 51

Solution

r 7 r#; > Beta /r6 - r#;1. r71.* #!74* r6712* B73 1.* 7 4* > Beta /12* - 4*1. 1.*-4*7BetaDG* 12*=G*7Beta 1.57Beta

5B-+ o! a !irm is #s. 1$$A Corporate +a& is @5* a1 52uity is 1$$* an) r5 is 2$* b1 (ebt is 1$$* an) -nterest is 1$* ;in) LACC. 6ar s 10

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a1 LACC 7 r( O(. > r0 O0 > r5 O5 . LACC7$>$>2$*/1$$1 LACC72$*

b1 L'en 1$$* )ebit r(/1-t1

1$*D/1-.@51 7$.$.5 7..5* LACC 7 r( O (. > r0 O0 > r5 O5 . LACC7..5*/1$$1 > $ > $ 7 ..5*

r(7 #ate o! (ebt O(7 weig'te) a"erage o! )ebt r07 rate o! 0ro!!ere) 9'ares O07 weig'te) a"erage o! pre!erre) s'ares r57 #ate o! e2uity /common s'ares1 O57 weig'te) a"erage o! e2uity 5B-+75arning be!ore -nterest P ta&es /gross pro!it1

1. #is !ree #ate is 15* an) e&pecte) 6ar et #eturn is 2$*. ;6 Corporation 'as a bet o! 1.B an) :ol) Corporation 'as beta o! 1.5. ;in) 5&pecte) #eturn on ;6 Corporation an) :ol) Corporation.

tt!"##grou!s$google$com#grou!#vuZs

r 7 r#; > Beta /r6 - r#;1. B71.B r672$* r#;715*

r715*>1.B/5*1

:ol) CompanyH B71.5 r672$* r#;715* r 7 r#; > Beta /r6 - r#;1. r715*>1.5/5*1

5B-+ o! a !irm is #s. 2$$ an) corporate ta& rateA +c is @$ *. -! t'e !irm is 1$$* 52uity an) r5 is 2$*. +'en calculate LACC.

LACC 7 r( O (. > r0 O0 > r5 O5 $ LACC7$>$>2$*/1$$1 LACC72$ *

12!lain t e e3uation o, 10)T / en it is e3ual to 0rea. 1ven +oint$ M&45S-6

An in)icator o! a companyQs pro!itabilityA calculate) as re"enue minus e&pensesA e&clu)ing ta& an) interest. 5B-+ is also re!erre) to as Roperating earningsRA Roperating pro!itR an) Roperating incomeRA as you can re-arrange t'e !ormula to be calculate) as !ollowsH 10)T 7 4evenue - 8!erating 12!enses

Also nown as 0ro!it Be!ore -nterest P +a&es /0B-+1A an) e2uals %et -ncome wit' interest an) ta&es a))e) bac to it.

Brea e"en 0ointH Nuantity o! 9ales at w'ic' 5B-+ 7 $ 5B-+ 7 8p #e"enue - 8p Costs 7 8p #e"enue - <ariable Costs ? ;i&e) Costs 7 0N - <N - ;. L'ere 07 0ro)uct 0rice /#s1A N7 Nuantity or S4nits 9ol)A <7 <ariable Cost /#s1A ;7 ;i&e) Cost /#s1. 9o -; 5B-+ 7 $ t'en 0N-<N-; 7 $ so Brea e"en N 7 ; = /0 - <1

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Calculate t'e m ar et "alue o! e2uity !or a 1$$* e2uity !irm using t'e !ollowing in!ormation e&tracte) !rom its !inancial statementsH 5B-+ 7 #s. 5$A $$$A return on e2uity is 12*A amount o! e2uity is #s. 1$$A $$$. ta& rate is @5*.

9oultion ;irst all all we net to calculate %et income

%et income 7 5B-+ ? -nterest ? ta& %et income 7 5$A$$$ ? $ ? /.@5D 5$A$$$1 7 @2A5$$

%ow to calculate t'e m ar et "alue o! !irm %et income= return on e2uity 7 @25$$=.12 7 2C$G@@.@ mar et "alue o! unle"erage) !rim /1$$* e2uity !irm1 e2uity > )ebit 7 2C$G@@.@ > $

7 2C$G@@

+'is solution is gi"en by our respecte) member & mad <s'a'za)senior@gmail.com>

S a 9ad

5arnings be!ore interest an) ta&es /5B-+1 o! ;irm is #s.1$$$ an) Corporate +a& #ateA +c is @$* a$ -! t'e ;irm is 1$$* 52uity /or 4n-Ee"ere)1 an) r 5 7 @$* t'en w'at is t'e LACC4 o! 4n-le"ere) ;irm3 Ans..... 11 %et income 7 5B-+ - - - +a& 7 1$$$ - $ - @$* /$.@1 7 C$$ 21 52uity /4n-E1 7 %-=#e 7 C$$=@$* /$.@1 7 2@@4 @1 LACC/4n-E1 7 52uity > (ebt 7 2@@4 > $ 9o 7 2@@4 Jere is note t'at wacc is e2ual to e2uity 7 @$* Titna e2uity rate 'oga ota'i LACC 'o o! 4nle"ere) !irm..... b$ -! t'e ;irm ta es #s.1$$$ (ebt at 1$* -nterest or 6ar -up t'en w'at is t'e LACC E o! Ee"ere) ;irm3 /+'ere is no c'ange in return in e2uity1 Ans...... 11%et income 7 5B-+ - - - +a& 7 1$$$ - .1/1$$$1 - @$* /B$$1 7 .@$ 21 52uity /4n-E1 7 %-=#e 7 .@$=@$* /$.@1 7 21$$ @1LACC /E1 7 52uity > (ebt 7 21$$ > 1$$$ 7 @1$$

;ormulaH... LACC 7 #)D/1 - tc1O) > #eDOe 7 .1D/1 - $.@1D/1$$$=@1$$1 > $.@D/21$$=@1$$1 7 $.225G$. 7 22.5G$.* 9'a'za)-9enior @r) 9emesterA ;aisalaba)A <irtual 4ni"ersity o! 0a istan. A 1$$* 52uity /un ? le"ere)1 !irm as total Assets o! #s. 5$$$$ weig'te) a"erage cost o! capital !or an un ? le"ere) !irm /LACC41 is @5* an) cost o! )ebt !or un ? le"ere) !irm /r ) u 1 o! 2$* it t'en a))s #s. 2$$$$ o! )ebt !inancial #is increases cost o! )ebts /r ) E1 o! le"er) ;irm to 1G* /6ar s 51 #e2uire) L'at is le"ere) !irms Cost o! e2uity /r e E13 L'at will be t'e LACC E o! le"ere) ;irm

&ssuming +ure MM :ie/ - )deal Mar.ets" +otal 6ar et <alue o! Assets o! ;irm /<1 is 4%CJA%:5(. <alue o! un le"ere) !irm 7 <alue o! le"ere) !irm. AlsoA LACC remains 4%CJA%:5( by Capital 9tructure an) (ebt. U LACC4 7 LACCE 7 @5*

#e 7 cost o! e2uity #) 7 1G * cost o! )ebt 5 7 mar et "alue o! t'e !irmQs e2uity ( 7 mar et "alue o! t'e !irmQs )ebt 7 <75>( 5=< 7 percentage o! !inancing t'at is e2uity (=< 7 percentage o! !inancing t'at is )ebt + 7 corporate ta& rate

#e 7 3 LACCu 7 @5*

r5AE 7LACC > (ebt=52uity /LACCE - r(AE1 #e 7 @5* > 2$$$=4G$$$/@5*-1G*1 @5.C$*

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LACC 7 5=< D#e > (=< D #) D /1- +1 %ow by plugging "alues <7 5>( 7 4G$$$>2$$$ 7 5$$$$ @5* 7 /4G$$$=5$$$$1 D #e > /2$$$=5$$$$1D 1G* by rearranging e2uation @5* 7 B.. #e > .$$C2 .B.#e 7 @5* - .$$C2 #e 7 /@5*-.$$C21 = .B. 7 @5.C$*

Cost o! 52uity !or Ee"ere) ;irm 7 r5AE 7 #is ;ree -nterest #ate > Business #is 0remium > ;inancial #is 0remium.

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-------------------------

BC in)ustries 'a"e a beta o! 1.5. +'e ris !ree rate is G* an) t'e e&pecte) return on t'e mar et port!olio is 1@ *. +'e company presently pays a )i"i)en) o! F5 a s'areA an) in"estors e&pect it to e&perience a growt' in )i"i)en)s o! 1$ percent per annum !or many years to come. a. L'at is t'e stoc ,s re2uire) rate o! return accor)ing to t'e CA063 b. L'at is t'e stoc ,s present mar et price per s'areA assuming t'is re2uire) return3

&)

Beta 7 5* #! 7 G* # m7 1@*

#e2urie) rate o! return 7 #! > /#m ? #!1 D beta

#e2uire) rate o! return 7 G*>/1@*-G*1D1.5 7 15.5*

0)

: 7 1$* (i"1 7 5

#e 7 /(i"1= 0o1> g

#e 7 /5=0o1> 1$* 15.5* - 1$* 7 5=0o 0o 7 5=15.5* 7 @2.5$ #s

-------

9toc E an) t'e Rmar etV 'as t'e !ollowing rates o! returns o"er t'e past !our years. ;ear Stoc. ( 2$$5--- 12.$$*----2$$.--- 5.$$* --2$$C--- 11.$$*-----Mar.et

14.$$* 2.$$* 14.$$*

2$$G--- -C.$$* ------ -@.$$* &dditional )n,ormation" .$* o! your port!olio is in"este) in 9toc E an) t'e remaining 4$* is in"este) in 9toc K. +'e ris -!ree rate is .* an) t'e mar et ris premium is also .*. Kou estimate) t'at 14* is t'e re2uire) rate o! return on your port!olio. L'ile 9toc E 'as t'e beta o! $.B4G4. 4e3uired" ;ou are re3uired to calculate t e beta o, Stoc. ;<

Beta o! port!olio

#e2urie) rate o! return 7 #! > /#m ? #!1 D beta 14* 7 .* > .* beta .* beta 7 G * Beta o! port!olio 7 G=. 7 1.@@

+'e beta o! a port!olio is simply t'e weig'te) a"erage o! t'e betas o! t'e stoc s in t'e port!olio

Beta o! port!olio 7 weig'te) a"erage o! E /beta o! E 1 > weig'te) a"erage o! K /beta o! K1 1.@@ 7 ../.B4G41 > .4 /beta o! K1 1.@@ - .5.B$4 7 .4 beta o! K

Beta o! K 7 .C.=.4 7 1.B$

12!lain t e ,ollo/ing conditions" -## <LACC -## >LACC> 96E

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-## <96E -## <LACC< 96E

9oultion

-## <LACC you s'oul) not in"est in t'is proWect as rate o! return is less t'en LACC. ot'er wor)s you can you your returns are less t'e cost o! capital. -## >LACC> 96E we s'oul) ta e t'is proWect as its rate o! rerun is 'ig'er t'en t'e LACC an) it o!!ers better rate or return t'en 5!!icient mar et o!!ers.

## <96E is s'owing rate o! return w'ic' is lower t'an 96E t'e company will not in"est because it is not gi"ing as muc' rate o! return as e!!icient mar et is o!!ering ## <LACC< 96E -## lower t'an LACC an) 96E company s'oul) not in"est as -## is not enoug' to co"er t'e LACC plus its returns are lower t'en returns o!!ere) by e!!icient mar et. Firms & and 0 are identical e2ce!t t eir use o, debt and t e interest rates t ey !ay$ Firm & as more debt and t us must !ay a ig er interest rate$ 4e3uirement" 0ased on t e data given belo/= o/ muc ig er or lo/er /ill be t e &>s 481 t at o, 0= i$e$= / at is 481 & - 4810 < &!!licable to 0ot Firms &ssets 4s$ ?=000=000 10)T 4s$600= 000 Ta2 rate ?6* Firm &>s -ata -ebt ratio @0* )nt$ rate 12* Firm (->s -ata -ebt ratio 20* )nt$ rate 10*

For com!any & @0* leverage so e3uity /ill be ?0* o, ?=000=000 7 A00000 10)T 7 600=000 )nterest (12* o, 600=000) 7 (B000) 10T CAC=000 Ta2 (?6* o, 10T) (1CD200) Eet incom e ?C6=D00 12!ected 481 (7E)#13uity) ?C6=D00# (A00000) 7 ?D$C2*

For com!any 0 20* leverage so e3uity /ill be D0* o, ?=000=000 7 2C00000

10)T 7 600=000 )nterest (10* o, 600=000) 7 (6000) 10T CA6=000 Ta2 (?6* o, 10T) (1CD600) Eet incom e ?CB=600 12!ected 481 (7E)#13uity) ?CB600# (2C00000) 7 1C$C?* 481& F 481 0 7 ?D$C2 F 1C$C? 72?$AA <ersionH Current by Xubair Jussain - 6ar 2 2. 5)it by Xubair Jussain - 6ar 2 1. Create) by Xubair Jussain - 6ar 1