9-10

The earnings, dividends, and stock price of Shelby Inc, are expected to grow at 7% per year in the
future. Shelby’s common stock sells for $23 per share, its last dividend was $2.00, and the company
will pay a dividend of $2.14 at the end of the current year.

Known:

g = 7%

P0 = $23

D0 = $2.00

D1 = S2.14

a. Using the discounted cash flow approach, what is its cost of equity?
D1
rs= +g
P0
2.14
rs= +0.07
23
rs=16.3 %

b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is
13%, then what would be the firm’s cost of equity based on the CAPM approach?
rs = rRF + (RPM)bi
= rRF + (RM - rRF)bi
= 9% + (13% - 9%)1.6
= 9% + 6.4%
= 15.4%

c. If the firm’s bonds earn a return of 12%, then what would be your estimate of r s using the
over-own-bond-yield-plus-judgmental-risk-premium approach?
rs = Company’s own bond yield + RPM
= 12% + 4%
= 16%

d. On the basis of the results of parts a through c, what would be your estimate of Shelby’s cost
of equity?
Cost of equity = (16.3% + 15.4% + 16%/3)
= 15.9%

9-12

Spencer Supplies’ stock is currently selling for $60 a share. The firm is expected to earn $5.40 per
share this year and to pay a year-end dividend of $3.60

Known:

P0 = $60

D1 = $3.60
EPS = $5.40

a. If investors require a 9% return, what rate of growth must be expected for Spencer?
D1
rs= +g
P0
3.60
0.09= +g
60
g=3 %

b. If Spencer reinvests earnings in projects with average returns equal to the stock’s expected
rate of return, then what will be next year’s EPS?
EPS1 = EPS0 x (1 + g)
= $5.40 x (1 + 0.03)
= $5.562

10-16

Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost
$100 million, and will produce net cash flows of $30 million per year. Plane B has a life of 10 years,
will cost $132 million, and will produce net cash flows of $25 million per year. Shao plans to serve
the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be
zero, and the company’s cost of capital is 12%. By how much would the value of the company
increase if it accepted the better project (plane)? What is the equivalent annual annuity for each
plane?

Plane A

The value of company will increase into $12.76 million

EAA = $2.26 million

Plane B

The value of company will increase into $9.26 million

EAA = $1.64 million

10-18

Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine.
Two new models are available: Machine 190-3, which has a cost of $190,000, a 3-year expected life,
and after-tax cash flows (labor savings and depreciation) of $87,000 per year; and Machine 360-6,
which has a cost of $360,000, a 6-year life, and after-tax cash flows of $98,300 per year. Knitting
machine prices are not expected to rise, because inflation will be offset by cheaper components
(microprocessors) used in the machines. Assume that Filkin’s cost of capital is 14%. Should the firm
replace its old knitting machine? If so, which new machine should it use? By how much would the
value of the company increase if it accepted the better machine? What is the equivalent annual
annuity for each machine?

Yes, the firm should replace the old kitting machine with the M 360-6. The value of company will
increase into $22.256