Doleh, Sufian FIN 501 7/13/2013 0:00

CSU ID 2356325
Chapter 09. Ch09 P18 Build a Model

INPUTS USED IN THE MODEL

P0 $50.00
Net Ppf $30.00
Dpf $3.30
D0 $2.10
g 7%
B-T rd 10%
Skye's beta 0.83
Market risk premium, RPM 6.0%
Risk free rate, rRF 6.5%
Target capital structure from debt 45%
Target capital structure from preferred stock 5%
Target capital structure from common stock 50%
Tax rate 35%
Flotation cost for common 10%

a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock (including
flotation costs), and the cost of equity (ignoring flotation costs). Use both the DCF method and the CAPM method to
find

Cost of debt:

B-T rd × (1 – T) = A-T rd
10% 65% 6.50%

Cost of preferred stock (including flotation costs):

Dpf / Net Ppf = rpf

$3.30 $30.00 11.00%

Cost of common equity, DCF (ignoring flotation costs):

D1 / P0 + g = rs
$2.25 $50.00 7% 11.49%

Cost of common equity, CAPM:

rRF + b × RPM = rs
6.5% 4.98% = 11.48%

IMPORTANT NOTE: HERE THE CAPM AND THE DCF METHODS PRODUCE APPROXIMATELY THE SAME
COST OF EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE
SAME RESULT. ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS.
b. Calculate the cost of new stock using the DCF model.

D0 × (1 + g) / P0 × (1 – F) + g = re
$2.25 $45.00 7% 11.99%

c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between r e and rs as
determined by the DCF method and add that differential to the CAPM value for r s.)

rs + Differential = re
11.48% + 0.50% = 11.98%

Again, we would not normally find that the CAPM and DCF methods yield identical results.

d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company's
WACC?

wd 45.0%
wpf 5.0%
ws 50.0%
100.0%

wd × A-T rd + wpf × rpf + ws × rs = WACC

2.93% 0.55% 5.75% = 9.22%

e. Suppose Gao is evaluating three projects with the following characteristics:

(1) Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred
stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for
the project. All equity will come from reinvested earnings.

(2) Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0%.

(3) Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%.

(4) Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%.

Analyze the company’s situation and explain why each project should be accepted or rejected.

Expected
return on
Beta rs rps rd(1 – T) WACC project
Project A 0.5 9.50% 11.00% 6.50% 8.23% 9%
Project B 1.0 12.50% 11.00% 6.50% 9.73% 10%
Project C 2.0 18.50% 11.00% 6.50% 12.73% 11%

Expected returns on Projects A and B both exceed their risk-adjusted WACC and, therefore, they should be accepted. On the other
hand, Project C's WACC exceeds its expected rate of return and, therefore, it should be rejected.