Case Narrative: A firm’s capital structure includes the following securities. It
ID: 2563832 • Letter: C
Question
Case Narrative:
A firm’s capital structure includes the following securities. It has 500,000 shares of common stock (equity) outstanding, selling for $20 per share. The preferred stock share price is $50, pays a $4 dividend with no growth expected. Each share of common stock sells for $20 and pays a $1.00 dividend, which is expected to grow by 2% per year. The current price of the bonds is $818, and the coupon rate is 5%. The bonds will mature in 10 years.
What is the market capitalization of the firm’s equity? ____________________________________________________ Chapter 4
What is the major factor that causes the market capitalization of a firm to increase or decrease? _____________________________________________Chapter 4
What is the cost (required rate of return) of the preferred stock? ______________________________________________________ Chapter 7
What is the cost (required rate of return) of the common stock? _______________________________________________________Chapter 7
What is the cost (yield to maturity %) of the bonds? _______________________________________________________Chapter 6
What caused the value of this bond to drop from $1,000 to $818? _______________________________________________________Chapter 6
Explanation / Answer
(i) Market capitalization of Firm's equity = No. of Common stock(equity) outstanding * Market Value per stock
= 500,000 shares * $20 = 10,000,000
(ii) Major factor that causes the market capitalization of a firm to increase or decrease are :-
Change in the value of shares, either upward or downward, in addition to a change in the number of issued shares of stock. The primary reason for this kind of change, however, is tied to the stock price. If there is high demand in a stock, the market Capitalization is likely to move higher, while weaker demand will hurt a company's value.
(iii) Cost of Preferred Stock = DPS/MPS = ($4/$50)*100 = 8%,
Where DPS = Dividend per share for preferred stock
MPS = the price at which preferred stock is selling
(iv) Cost of the Common Stock = (D/S)+g = ($1.02/$20) + 0.02(2%) = 0.071 (i.e. 7.1%)
Where, D = dividend payment (expected to be paid in next year) [i.e. $1 * 1.02 (growth) = $1.02]
S = Current stock value
g = growth rate of dividend
(v) Yield to maturity = [I+(M-B0)/n]/(M+B0)/2 = [50+(1,000-818)/10]/(1,000+818)/2 = [50+18.20]/909 = 0.075(i.e.7.5%)
where, I = Annual Interest on Bond (1,000*5% = 50)
M = Maturity value (i.e. Face value)
B0 = Market Value
n = periods to maturity
(vi) As Yield to maturity(7.5%) of Bond calculated in above part is more than the bond's coupon rate (5%), It means that the Bond is selling at discount. Therefore the value of this Bond drop from $1,000 to $818.
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