11/20/2019 Corporate Finance

Student Name
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Calculations:

Problem 1

Data:
Initial Price of stock = $100
Ending share price= $125
Dividend Paid= $2

Solution:

Total return=Capital gain yield + Dividend yield

Price at the ending−Price at the beginning

Capital gain yield=
Price at the beginning

$ 125−$ 100
Capital gain yield=
$ 100

Capital gain yield=0.25=25 %

Dividend paid
Dividend yield=
Price at the beginning

$2
Dividend yield=
$ 100

Dividend yield=0.02=2 %
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Total return=Capital gain yield + Dividend yieldTotal return=25 % +2 %

Total return=27 %

Problem 2
Data:
Preferred stock was purchase at = $100
Dividend yield= 4%
Current Market price of stock = $120
Total return=?

Solution:

Dividend received ( $ )=Dividend yield∗Purchase price of stock

Dividend received ( $ )=4 %∗$ 100

Dividend received ( $ )=$ 4

Current price−Purchase price+ Dividend received

Total Return=
Purchase price

$ 120−$ 100+$ 4
Total Return= Total Return=24 %
$ 100

Problem 3

Data:
Stock Beta=β=1.20
Expected Market return=r m=12 %
Risk free rate=r fr =5 %
Expected rate of return=r exp=?
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Solution:
Expected rate of return=r exp=¿=r fr + β∗(r m −r fr)¿

Expected rate of return=5 %+1.2∗(12 %−5 %)

¿ 5 %+ 1.2∗(12 %−5 %)
¿ 5 %+ 1.2∗(12 %−5 %)
¿ 5 %+ 8.4 %
E xpected rate of return=r exp=13.4 %

Problem 4

Data:
Proportion of Common stock ∈targeted capital structure=w e=80 %
Proportion of Debt ∈targeted capital structure=w d=20 %
Cost of equity=r e=12%
Cost of debt =r d =7 %
Tax rate=t=30 %
Weighted average cost of capital=WACC =?

Solution:

WACC=wd . r d .( 1−t)+ we . r e
WACC=wd . r d .( 1−t)+ we . r e
WACC=20 %∗7 %∗( 1−30 % ) +80 %∗12 %
WACC=10.58 %

Problem 5

Data:
Debt-equity ratio= 0.75
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Cost of new plant= $125

Flotation cost of issuing new equity= 10%
Flotation cost of issuing new debt= 4%
Initial cost of the plant=?

Solution:
Since Debt-equity ratio= 0.75/1= 0.75
Debt-Asset ratio= 0.75/ (1+0.75) = 0.4286
Equity-Assets ratio= 1- 0.4286= 0.57143

Total Flotation cost=( The flotation cost of debt∗Debt ¿ asset ratio ) + ( The flotation cost of Equity∗Equi

Total Flotation cost=( 4 %∗0.4286 ) + ( 10 %∗0.57143 )

Total Flotation cost=( 4 %∗0.4286 ) + ( 10 %∗0.57143 )
Total Flotation cost=1.7143 %+5.7143 %
Total Flotation cost=7.4286 %

Cost
The initial cost of plant−based on raising all equity externally=
( 1−Flotation cost %)

$ 125
The initial cost of plant−based on raising all equity externally=
( 1−7.4286 %)

Initial cost of plant based on raising all equity externally=$ 135.0309 Million

Or with another method,

Portion of cost of plant funded through debt= $125 Million * 42.86%= $53.571
Million
Flotation cost on Debt=$53.571 Million * 4%=$2.143 Million
Portion of cost of plant funded through Equity= $125 Million * 57.143%= $71.428
Million
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Flotation cost on Equity=$ 71.428 Million∗10 %=$ 7.143 Million

Total Flotation cost=$ 2.143 Million+ $ 7.143 Million
Total Flotation cost=$ 9.2857 Million
Initial cost of Plant=$ 125+ $ 9.2857=$ 134.2857 Million

Summary
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One of the basic premises of making any financial decision specifically investment
decision is that investors like return, but they dislike risk, therefore they will invest in
risky assets only if the expected return on them is higher than expected risk. In case
the expected return on the stock is considered lower to reward for the expected risk,
investors will start selling it, driving down its price, and therefore increasing its
expected return.On the other hand, if the expected return on the stock is higher than
expected risk, investors will start buying it, and, raising its price and thus lowering
expected return. [ CITATION Eug12 \l 1033 ] Stock’s return is composed of two parts, 1)
Capital gain 2)Dividend yield. The capital gain/loss tells us about change in the price
of the stock, on the other hand,the dividend is a premium that a company pays to its
investors for using their money.Generally, safe companies are likely to have low to
moderate total returns, and higher risk companies are likely to have higher returns.In
1st question, we have calculated stock value based on its total return.The capital of
stock is 25% and dividend yield is 2%, hence total return on the common stock is
27%. In 2nd question we have calculated total return of preferred stock. It is 24%.
Since common stockholders have residual claims on the company’s assets and
earnings, preferred stockholders are paid first. So, the return on common stock must
be higher than preferred stock to compensate investors for higher risks.Capital Asset
Pricing Model (CAPM), is used for calculating the expected return of an asset. It
describes the relationship between the expected return and risk of a security. This
model is a perfect depiction of how investors incorporate risk of a security in the form
of Beta, for calculating its expected return. Beta represents the stock’s sensitivity to
market risk, the risk which cannot be diversified away, so the investors need to be
compensated for it in the form of risk premium which is the difference of expected
market return and risk-free rate.[ CITATION CFI \l 1033 ] According to Investopedia
(2019), “Broadly speaking, a company’s assets are either financed by either debt or
equity. WACC is the weighted average of the cost of these financing, each of which
is weighted by its respective use in the given situation. By taking a weighted average,
we can see how much interest the company has to pay for every dollar its finances”
[ CITATION Mar19 \l 1033 ]. However, WACC needs to be adjusted with the flotation
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cost of the company so that it can better assist in the decision making of the capital
budgeting process. Flotation cost is the cost that company incurs whenever it raises
equity externally. These measures enable financial managers within an organization
to make better intelligent investment decisions when it comes to capital budgeting
process.

References
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Eugene F. Brigham, J. F. (2012). Fundamentals of Financial Management. Cengage

Learning.

Hargrave, M. (2019, June 30). Weighted Average Cost of Capital-WACC. Retrieved from
Investopedia: https://www.investopedia.com/terms/w/wacc.asp

Institute, C. (n.d.). Retrieved from

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-capm-
formula/