| Problem Assignments and Solutions - Capital Structure |
| 1 | The corporate treasurer of Ajax Company expects the company to grow at 4% in the future, and debt securities |
| | at 6% interest (tax rate = 30%) 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 | | | 4.20% |
| | | Cost of retained earnings is | | | 7.85% |
| 2 | The risk-free rate on 10-year U.S. Treasury bills is 3% and the expected rate of return on the overall stock market is 11%. |
| | The company has a beta of 1.6. What is the cost of equity? |
| | Answer: | The cost of equity is | | 15.80% |
| 3 | A company has a capital structure as follows: |
| | Total Assets | | $600,000 |
| | Debt | | $300,000 |
| | Preferred Stock | | $100,000 |
| | Common Equity | | $200,000 |
| | 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 11%, 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 $2 and $7, repectively, in one year. The company's dividends |
| | are expected to grow at 13% 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. |
| | | Cost of debt after tax is | | 6.60% |
| | | Cost of preferred stock is | | 7.92% |
| | | Cost of common stock is | | 18.04% |
| | | WACC is | | 10.63% |
| 4 | Required rate of return is 10%. |
| | | Net Cash Flow |
| | Year | Project A | Project B |
| | 0 | -$2,000 | -$2,500 |
| | 1 | $900 | $1,500 |
| | 2 | $1,100 | $1,300 |
| | 3 | $1,300 | $800 |
| a) | Calculate the payback period for each project. |
| | | Project A | Project B |
| | Answer: | 2.00 | 1.77 | Payback Period in years. |
| b) | Calculate the net present value for each project. |
| | | Project A | Project B |
| | Answer: | $703.98 | $539.07 |
| c) | Which project do you think will be approved, if only one project can be approved? Why? |
| | | Project A | Project B |
| | Answer: | Yes | No |
| d) | What if the required rate of return was 20%? |
| | Answer: | Project A | Project B |
| | | $266.20 | $115.74 | Net Present Value |
| | | Yes | No |
| 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 $872. To the nearest whole percent, |
| | what is the yield to maturity (YTM) of the bond today? |
| | Answer: | 9% |
| 6 | Ajax 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 14%. |
| a) | What should be the current market price per share? |
| | Answer: | $72.73 |
| b) | What is the annual rate of return if you purchase the stock at $65? |
| | Answer: | 15.31% |
| 7 | A common stock sells for $82 per share, has a growth rate of 7% and a dividend that was just paid of $3.82. What is the |
| | annual percent yield per share? |
| | | D0 = $3.82 and therefore D1 = $3.82 x 1.07 = | | | | $4.09 |
| | Answer: | 11.98% |
| 8 | 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 $1,027, and it will mature at $1,100. |
| | To the nearest whole percent, what is the yield to maturity (YTM) of the bond today? |
| | Answer: | 6% |
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week_5_questions_.xls
