Question 11-2

Tunney Industries can issue perpetual preferred stock at a price of $50 a share. The issue is expected to pay a
constant annual dividend of $ 3.80 a share. The floatation cost on the issue is estimated to be 5 percent. What is the
company’s cost of preferred stock, kps?

Solution:

Market Price = 50

Annual Dividend = 3.8

Flotation Cost = 5%

Cost Of Preferred Stock Kps = Dividend / (Market Price * (1- Flotation Cost%)

= 3.8 / (50 x (1 - 0.05))

= 8%

Question 11-6

Trivoli Industries plans to issue some $100 par preferred stock with an 11 percent dividend. The stock is selling on
the market for $97.00, and Trivoli must pay flotation costs of 5 percent of the market price. What is the cost of the
preferred stock for Trivoli?

Solution:

Market Price P = 97

D1 = 11% of 100 (Par Value) = 11

Flotation Cost = 5%

Cost Of Preferred Stock Kps = Dividend / (Market Price * (1- Flotation Cost%)

= 11 / (97 x (1 - 0.05))

= 11.94%

Question 2.

Using the capital-asset pricing model, determine the required return on equity for the following situations:

Solution:
 Required Return On
Expected Return On
Situation Risk Free rate Beta Equity = Re = Rrf +
Market Portfolio
B(Rm - Rrf)

1 15% 10% 1 15.0%

2 18% 14% 0.7 16.8%
3 15% 8% 1.2 16.4%
4 17% 11% 0.8 15.8%
5 16% 10% 1.9 21.4%

The Sprouts-N-Steel Company has two divisions: health foods and specialty metals. Each division employs debt equal
to 30 percent and preferred stock equal to 10 percent of its total requirements, with equity capital used for the
remainder. The current borrowing rate is 15 percent, and the company’s tax rate is 40 percent. At present, preferred
stock can be sold yielding 13 percent.

Sprouts-N-Steel wishes to establish a minimum return standard for each division based on the risk of that division.
This standard then would serve as the transfer price of capital to the division. The company has thought about using
the capital-asset pricing model in this regard. It has identified two samples of companies, with modal value betas of
0.90 for health foods and 1.30 for specialty metals. (Assume that the sample companies had similar capital
structures to that of Sprouts-N-Steel.) The risk-free rate is currently 12 percent and the expected return on the
market portfolio 17 percent. Using the CAPM approach, what weighted average required returns on investment
would you recommend for these two divisions?

Solution:

Debt Proportion Wd = 0.3

Preferred Stock Proportion Wps = 0.1

Common Stock Porportion Ws = 0.6

Tax Rate = 40%

Borrowing Rate rd = 15%

After Tax rd = 15(1-0.4) = 9%

Cost Of Preferred Stock rps = 13%

Specialty Metal Division:

b = 1.3

Rf = 12%

Rm = 17%

Rs = Rf + b x (Rm - Rf) = 12 + 1.3 x (17 - 12) = 18.5%

WACC =Wd x rd + Wps x rps + Ws x rs

WACC = 0.3 x 9% + 0.1 x 13% + 0.6 x 18.5% = 15.1%

Health Division:

b = 0.9

Rf = 12%
Rm = 17%

Rs = Rf + b x (Rm - Rf) = 12 + 0.9 x (17 - 12) = 16.5%

WACC =Wd x rd + Wps x rps + Ws x rs

WACC = 0.3 x 9% + 0.1 x 13% + 0.6 x 16.5% = 13.9%