(Common equity—capital asset pricing model) Treasury bonds currently yield 8.5%,

Question

(Common equity—capital asset pricing model) Treasury bonds currently yield 8.5%, and the market price of portfolio risk has been estimated to be 8.3%. Calculate investors’ required rate of return from a stock with beta coefficient of:

a. 0?

b. .75?

c. 1.0?

d. 1.25?

. (Common equity—bond-yield-plus-premium model) A company’s stock’s historical return has been 5% above its long-term bond yield. What would this relationship predict for investors’ required rate of return from the stock if the bond yield were:

a. 8%?

b. 11%?

c. 13%?

d. 16%?

Bonds) A company has an outstanding issue of $1,000 face value bonds with a 8.75% annual coupon and 10 years remaining until maturity. The bonds are currently selling at a price of 82.50 (82.50% of face value). The company wishes to sell a new bond issue with a 30-year maturity. Their investment bank has advised that (1) the new 30-year issue could be sold for a flotation cost of 3% of face value, and (2) current yield curves indicate that 30-year maturity bonds yield a nominal 75 basis points (0.75%) more than 10-year maturity bonds on average. The company is in the 35% tax bracket.

a. Calculate investors’ required rate of return today.

b. What annual coupon would have to be placed on the new issue in order for it to sell at par?

c. Calculate the flotation cost and tax savings from the proposed new issue.

d. Calculate the cost of the new bond financing.

(Preferred stock) A company has an outstanding issue of $100 face value fixed-rate preferred stock with an annual dividend of $18 per share. The stock is currently selling at $110 per share. An investment bank has advised that a new preferred-stock issue could be sold for a flotation cost of 6% of face value. The company is in the 35% tax bracket.

a. Calculate investors’ required rate of return today.

b. What annual dividend rate would have to be placed on the new issue for it to sell at par?

c. Calculate the flotation cost and tax savings from the proposed new issue.

d. Calculate the cost of the new preferred-stock financing.

Explanation / Answer

1.According to CAPM
Cost of Equity = Risk free rate + beta * risk premium

a) When Beta coefficient = 0
Cost of Equity = 8.5% + 0 * 8.3% = 8.5%
When Beta coefficient = 0.75
Cost of Equity = 8.5% + 0.75 * 8.3% = 14.725%
When Beta coefficient = 1.0
Cost of Equity = 8.5% + 1.0 * 8.3 %= 16.8%
When Beta coefficient = 1.25
Cost of Equity = 8.5% + 1.25 * 8.3% =18.875%
2.Bond-yield-plus-premium model
Required return of equity = 5% + Bond yeild

When bond yield =8% Cost of Equity =5%+8% =13%
When bond yield =11% Cost of Equity =5%+11% =16%
When bond yield =13% Cost of Equity =5%+13% =18%
When bond yield =16% Cost of Equity =5%+16% =21%

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