Case Equation

Column1 Coupun rate semi-anuall interestyear of maturityN MARKET RATE OF RETURNPAR STATED RATEB0ND VALUE DEBT COST BEFORE TAXDEBT COST AFTER TAX 1000 Coupon 0.09 2 22 44 14.00% $1,000 8.00% $2,220.21 12.00% 6.60%

assuming face value to be $1000 Coupon= 0.09*1000=90/2= 45.Number of periods=22*2= 44. Before tax cost of debt=11% Keys to use in a finacial calculator: 2nd I/Y 2, FV 1000, PV -835.42, N44, PMT 45, CPT I/Y 2

The calculation here is correct for Q1.

I don't understand what you're calculating. Why do you have Debt cost of capital 12%? Didin't you just calculate it as 11% in Q1? And why did you use 0.1x(1-0.34) to get 6.6% for Q2? Shouldn't the after-tax cost of debt = Before-tax cost of debt x (1-Tax rate)? Tax rate in this problem is 40%, isn't it?

+2.5/7

CAPM Model cost of equity= risk free rate of return+ Beta* (market rate of return- Risk free rate of return)

Column1 Column2

risk-free rateof return 8.00% beta 1.1 market rate of return 14.00% 12.00% cost of equity 14.60%

Column1 weight cost weighted cost

Debt after tax 0.00% 0.00% 0.00% Equity 100.00% 14.60% 14.60% Cost Of Capital (WACC) 14.60%

After-tax WACC = Portion of debt financing x After-tax cost of debt + Portion of equity financing x Cost of equity + Portion of preferred stock financing x cost of preferred stock. Please read the problem carefully. The company does not use 100% euqity financing. The company uses both equity and debt financing; find out what the portition of each source of financing.

Dividend $1.15 beta 1.1 abnormal growth rate 30% constant growth 8% Rm 14% RF 8%

Rs= RF+(rMA-Rrf)B 14.600%

D0 D1 D2 D3 D4 D5 D6 D7 D8 D9 D10 $1.15 1.495 1.9435 2.52655 3.284515 4.26987 5.55083 7.216079 9.380903 12.19517 15.85373

Calculations for D1~D4 are correct.

All the dividend calculations starting from year 5 are incorrect. The dividend grows at 8% starting from year 5. You still use the 30% growth rate.

This problem relates to the valuation of common stocks with non-constaant dividend growth. You can find the relevant materials in the textbook in Ch7, or in Ch7 PPT slides starting from Slide 41 afterwards. In this problem since the stock restores to a constant dividend growth rate at 8% starting from year 5, you can summarize all the future dividend income streams from year 5 into an equivalent value at the rnd of year 4 by the constant dividend growth formula, P4=D5/(Ke-g), where Ke=14.6% (the cost of equity) and the growth rate = 8%. Once you get P4, to calculate the stock price today, you sum the present value of D1, the present value of D2, the preent value of D3, and the present value of (D4+P4). You can use a financial calculator to sum these present values and we provide you how to implement it in Ch7 slides 46, 52....Also, a spreadsheet is uploaded in the course website to illustrate you how to implement it using the spreadsheet.

D11 D12 20.60984 26.7928

year cash flow Present value interest

0 $1,000,000 1000000 8.00%

1 $500,000 462962.963

2 $400,000 342935.528

3 $300,000 238149.672

4 $100,000 73502.9853

net present value 2117551.15

internal rate of return #NUM!

1. Why do you use 8% as the interest rate for your valuation of the capital investment project? The after-tax WACC should be used, which is calculated in Q4. 2. In Year 0, 1000 is the investment cost, a cash outflow. Why do you have it as a cash infow?