Growth rate of dividends and common stock share price 4% Interest rate = 6% Risk
ID: 2648097 • Letter: G
Question
Growth rate of dividends and common stock share price 4%
Interest rate = 6%
Risk free rate of return = 5%
Return on the market = 12%
Tax bracket = 40%
Dividend on common stock (past year) = $3
Dividend on preferred stock = $4
Price per share of common stock = $30
Price per share of preferred stock = $100
Beta = 1.3
Assume that items in the balance sheet below are in the desired proportion. (The current capital structure is the target capital structure.)
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Assets $100,000,000 Long -term debt $45,000,000
Preferred stock $10,000,000
Common stock $30,000,000
Retained earnings $15,000,000
a. What is this firm
Explanation / Answer
a) cost of equity as per CAPM would be
Risf free rate + Beta * ( Market rate of return - risk free rate)
= 5% + 1.3 ( 12%-5%)
=5%+ 9.1%
= 14.1%
cost of preferred stock = dividend paid/issue price = 4/100 = 4%
cost of debt = Interest rate * (1-tax rate)
= 6% * (1-40%)
=3.6%
WACC = proportion of equity in total capital * cost of equity + proportion of preferred stock * cost of preferred stock + proportion of debt * cost of debt
Proprtion of
Long term debt = 0.53
Preffered stock = 0.12
Common stock = 0.35
wacc = 0.53* 3.6% + 0.12 * 4% + 0.35*14.10% = 7.35%
b) Dividend growth model
Price = dividend/required rate of return - expected growth rate
Price = 30, dividend = $3, required rate of return = ?, expected growth rate = 4%
30 = 3/x-4% = 14.0%
WACC = proportion of equity in total capital * cost of equity + proportion of preferred stock * cost of preferred stock + proportion of debt * cost of debt
Proprtion of
Long term debt = 0.53
Preffered stock = 0.12
Common stock = 0.35
wacc = 0.53* 3.6% + 0.12 * 4% + 0.35*14.0% = 7.32%
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