Problem Assignments and Solutions – Capital Structure Calculate


Question Description:

35

Problem Assignments and Solutions – Capital Structure
Calculate the correct answer in all problems
USE NPV, Rate, and IRR Functions as appropriate in Problems 4b, 4d. 4e, 5, and 8
Explain in words what you do to make each calculation
Explain in words what the answers mean
Points
1

The corporate treasurer of Rollinsford Company expects the company to grow at 3% in the future,
and debt securities at 4% interest (tax rate = 35%) to be a cheaper option to finance the growth.
The current market price per share of its common stock is $39, and the expected dividend in one
year is $1.50 per share. Calculate the cost of the company’s retained earnings and check if the
treasurer’s assumption is correct.

Answer: Cost of debt after tax is
Cost of retained earnings is

2-A

2-B

2.60%
6.85%

The risk-free rate on 30 year U.S. Treasury bonds is 3.25% and the expected rate of return on
the overall stock market is 12%. The company has a beta of 1.6. What is the cost of equity?

Answer: The cost of equity is

3

17.25%

Les argues that the 10 year note is a better risk free rate at 2%. He also argues that the stock
market is too high and the expected return is really only 5%. Assume that he is correct. The
company has a beta of 1.6. What is the cost of equity?
Answer: You calculate

10

7

3 A company, West Berwick Enterprises, has a capital structure as follows:
Total Capital
$1,000,000
Debt
$400,000
Preferred Stock
$100,000
Common Equity
$500,000
What would be the minimum expected return from a new capital investment project to satisfy the
suppliers of the capital? Assume the applicable tax rate is 40%, interest on debt is 7%, flotation
cost per share of preferred stock is $0.75, and flotation cost per share of common stock is $4.
The preferred and common stocks are selling in the market for $26 and $143 a share respectively,
and they are expected to pay a dividend of $1.50 and $4.50, respectively, in one year. The
company’s dividends are expected to grow at 7% per year. The firm would like to maintain the
existing capital structure to finance the new project.

Answer:

The minimum expected return from a new capital investment project is the WACC plus
any additional risk premium. Since no additional risk is mentioned, we will use the
WACC. The results of the calculations are below.

Cost of debt after tax is
Cost of preferred stock is
Cost of common stock is
WACC is

4.20%
5.94%
10.24%
7.39%

15

4

West Berwick is considering two projects for a new investment, but it can afford only one. It
has determined that the appropriate discount rate is 7.39%. Please answer the following
questions based on the data below:

Year
0
1
2
3
4
5

Net Cash Flow
Project A
-$4,000,000
$800,000
$1,000,000
$1,200,000
$1,400,000
$1,600,000

Project B
-$5,000,000
$1,900,000
$1,700,000
$1,400,000
$900,000
$300,000

4-A Calculate the payback period for each project.
Project A
Project B
Answer:
3.71
3.00
Payback Period in years.

6

4-B Calculate the net present value for each project.
Project A
Project B
Answer: $753,814.54 $260,470.16

6

4-C Which project do you think will be approved, if only one project can be approved? Why?
Project A
Project B
Answer:
Yes
No

3

4-D What if the required rate of return was 10%?
Answer:
Project A
Project B
$404,989.72 ($14,939.37) Net Present Value
Yes
No
4-E What is the Internal rate of return?
Answer:
Project A
Project B
13.45%
9.85%

6

6

4-F Which is the best to use for deciding: Payback, NPV or IRR? Why?
Answer: Your answer

5

A corporate bond has a face value of $1,000 and an annual coupon interest rate of 7%. Interest
is paid annually. 10 years of the life of the bond remain. The current market price of the bond is
$1232. To the nearest 1/100 0f 1 percent, what is the yield to maturity (YTM) of the bond today?

Answer:

6-B

6

$200.00

If you buy the stock in Kennebunk (above) at $185 and the stock price grows at the expected rate,
What would be your percent return after one year?
Answer:

6

4.12%

6-A Kennebunk Manufacturing is expected to pay a dividend of $8 per share next year. The dividend
growth rate is expected to continue to be 3%. Required rate of return is 7%. What should be the
current market price per share?

Answer:

8

7.32%

6

7

On January 15, 2013, A common stock sells for $82 per share, has a growth rate of 7% and a
dividend that was just paid of $3.82 in December 2012. What is the annual percent yield per
share?
Answer:

8

11.98%
11.99%

Either answer acceptable

A corporate bond has a face value of $1,000 and an annual coupon interest rate of 6%. Interest
is paid annually. 12 years of the life of the bond remain. The current market price of the bond is
$1,127, and it will mature at $1,000. To the 1/10 percent, what is the yield to maturity (YTM) of
the bond today?

Answer:

6

6

4. 6%
Total Points

100

Answer

35