Use the following information for questions 18-24. A corporation has 12,000,000
ID: 2624964 • Letter: U
Question
Use the following information for questions 18-24. A corporation has 12,000,000 shares of stock outstanding at a price of $30 per share. They just paid a dividend of $2 and the dividend is expected to grow by 5% per year forever. The stock has a beta of 1.2, the current risk free rate is 4%, and the market risk premium is 6%. The corporation also has 400,000 bonds outstanding with a price of $950 per bond. The bond has a coupon rate of 7% with semiannual interest payments, a face value of $1,000, and 13 years to go until maturity. However, it can be called in 6 years for a call premium of $1,050. The company plans on issuing new debt until they reach their target debt ratio of 70%. They expect their cost of debt to be 11% and their cost of equity to be 15% under this new capital structure. The tax rate is 40%
18. What is the CAPM required return on the corporation's stock?
19. What is the expected return on the corporation's stock?
20. What is the relevant yield on the company's debt?
21. What percent of their current market value capital structure is made up of debt?
22. What is their WACC using their target capital structure and expected costs of debt and equity?
23. Given the new cost of debt, what should be the new price of the bond?
24. Given the new cost of equity, what should be the new price of the stock?
Explanation / Answer
18. What is the CAPM required return on the corporation's stock?
CAPM required return = 4% +1.2*6%= 11.20%
19. What is the expected return on the corporation's stock?
P= D1/(r-g)
30 = 2*1.05/(r-5%)
r= 12.00%
20. What is the relevant yield on the company's debt?
Let yield be rd
Price= present value of future cash flows
950 = 7%*1000/2*(1-1/(1+rd/2)^26)/r + 1000/(1+rd/2)^26
Rd= 7.61%
the relevant yield = 7.61%
21. What percent of their current market value capital structure is made up of debt?
Debt = 400000*950=$380,000,000
Equity = 12000000*30=$360000000
Percentage of debt = 380,000,000/(380,000,000+360000000)= 51.35%
22. What is their WACC using their target capital structure and expected costs of debt and equity?
WACC = 70%*11%*(1-40%) + 30%*15%= 9.12%
23. Given the new cost of debt, what should be the new price of the bond?
Price of bond = = 7%*1000/2*(1-1/(1+11%/2)^26)/5.5% + 1000/(1+11%/2)^26= $726.75
24. Given the new cost of equity, what should be the new price of the stock?
Price = 2*1.05/(15%-5%)=$21