Question Based the data in Table 1, what is a reasonable range for the PNC’s cos
ID: 2783235 • Letter: Q
Question
Question
Based the data in Table 1, what is a reasonable range for the PNC’s cost of common equity based on the own-bond-rate-plus-risk-premium approach? Based on the Table 1 data, what is a reasonable range for the CAPM estimate?
Table 1. Data Used in the Analysis
a.Bond Data.
Two dollar-denominated bonds are currently outstanding. Bond A has a 6.75 percent semiannual coupon, sells for 88.75 percent of par, matures on July 1, 2029, and can be called at a price of 105 on July 1, 2009. Bond B has a 9.0 percent semiannual coupon, sells for 112.25 percent of par, also matures on July 1, 2029, and can be called at a price of 107.50 on July 1, 2009. PNC’s federal-plus-state tax rate is 40 percent. Assume that the analysis is conducted on September 15, 2004, and use this as the settlement date, i.e., the day the bond will be purchased. New bonds carrying the prevailing rate could be sold to institutional investors, and no bond flotation cost would be involved.
b. Preferred Stock Data.
PNC has one issue of preferred stock outstanding, a perpetual and non-callable preferred that pays a $6.25 annual dividend, has a $100 par value, and currently sells for $104 per share. Investment bankers have indicated that PNC could sell additional shares with a dividend rate that would provide the same market yield, but would incur a flotation cost of 2%. Also, it could sell at par an issue of sinking fund preferred with an annual coupon of 5.25%. The sinking fund would require the company to retire 10% of the original shares each year after issuance, and it too would have a 2 percent flotation cost.
c. Common Equity Cost Data
• Over Own Bond Risk Premium. The own-bond subjective risk premium is assumed to be in the range of 3% to 5%.
• CAPM. PNC’s estimated beta coefficient is 1.35, with a reasonable range of 1.15 to 1.55. The risk-free rate is 4.8%, and the market risk premium (RPM) is estimated to be 5.0%, with a range of 4.0% to 6.0%.
• DCF. PNC’s stock sells for $21 per share. The company currently does not pay a dividend, but its long-run business plan calls for a dividend of $0.50 per share to paid at the end of 2007. The plan also forecasts a growth rate of 75% in 2008, 40% in 2009, and 7.5% thereafter. These specific growth rates have not been reported to the public, but information that has been released provides guidance that has lead analysts to similar but not exact forecasts.
• Common Equity Flotation Costs and Market Pressure.
Amount of stock issues: fee applies to all equity raised up to this amount
(thousands)
Common % flotation
Cost; includes market pressure
Net price with
$21 base
0
0%
$21.00
$5000
10%
$18.90
$10,000
25%
$15.75
$20,000
40%
$12.60
d.Potential Capital Budgeting Projects
Project
Cost
Rate of return (iRR)
Cumulative cost
A
$3,000
15%
$3000
b
$5,000
14%
$8000
c
$3,000
13.5%
$11,000
d
$4,000
13%
$15,000
e
$4,000
12.5%
$19,000
f
$2,000
12%
$21,000
g
$2,000
11%
$23,000
h
$2000
10%
$25,000
i
$2,000
9%
$27,000
e. Euro Denominated Debt
Maturity: 1 year.
Amount borrowed: $115.
Rate on euro-denominated 1-year debt: 7.0%.
Rate on dollar denominated 1-year debt: 6.0%.
Current exchange rate: 1.15 dollars per euro.
Forecasted year-end exchange rate: 1.13 dollars per euro.
Amount of stock issues: fee applies to all equity raised up to this amount
(thousands)
Common % flotation
Cost; includes market pressure
Net price with
$21 base
0
0%
$21.00
$5000
10%
$18.90
$10,000
25%
$15.75
$20,000
40%
$12.60
Explanation / Answer
Ans:
In the bond rate plus risk premium approach the risk premium is added to bond yield. Accordingly the cost of equity is computed in the following manner:
Ke= Bond rate+ Risk Premium
Bond rate is ranging from 6.75% to 9% and risk premium is ranging from 3 to5%. So the cost equity will be in the following range:
Ke= 6.75+3= 9.75%
Ke= 6.75+5= 11.75%
Ke= 9+3= 12.00%
Ke= 9+5= 14%
So, the cost of common equity would be in the range of 9.75% to 14%.
CAPM Approach
Under CAPM approach the cost of equity is computed in the following steps:
-Estimate Risk Free Rate (Rf)
- Estimate stock’s
- Estimate expected market return (Rm)
The cost of equity is computed by using the following equation:
Ke= RFR+ (Rm- Rf)
Ke= 4.8%+1.35(5%)= 11.55%
If the risk premium is 4%
Ke= 4.8%+1.35(4%)= 10.20%
If the risk premium is 6%
Ke= 4.8%+1.35(6%)= 12.90%
If Beta is 1.15
Ke= 4.8%+1.15(4%)= 9.40%
Ke= 4.8%+1.15(5%)= 10.55%
Ke= 4.8%+1.15(6%)= 11.70%
If Beta is 1.55
Ke= 4.8%+1.55(4%)= 11.00%
Ke= 4.8%+1.55(5%)= 12.55%
Ke= 4.8%+1.55(6%)= 14.10%
So as per CAPM estimate the cost of equity would be in the range of 9.40% to 14.10%.