1. Quantitative Problem: Barton Industries estimates its cost of common equity b
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Question
1.
Quantitative Problem: Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, D1, to be $2.40 and it expects dividends to grow at a constant rate g = 4.8%. The firm's current common stock price, P0, is $22.00. The current risk-free rate, rRF, = 4.4%; the market risk premium, RPM, = 5.7%, and the firm's stock has a current beta, b, = 1.2. Assume that the firm's cost of debt, rd, is 9.77%. The firm uses a 3.7% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places.
2.Quantitative Problem: Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 9%.
What is Project A's NPV? Round your answer to the nearest cent. Do not round your intermediate calculations. $______
What is Project B's NPV? Round your answer to the nearest cent. Do not round your intermediate calculations. $______
Explanation / Answer
Part A)
The firm's cost of equity with the use of 3 approaches will require the use of different formulas as follows:
CAPM Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium)
Bond-Yield-Plus-Risk-Premium = Cost of Debt + Risk Premium
DCF Model = D1/Current Stock Price + Growth Rate
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Using the information provided in the question, we get,
CAPM Cost of Equity = 4.4 + 1.2*5.7 = 11.24%
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Bond-Yield-Plus-Risk-Premium = 9.77 + 3.7 = 13.47%
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DCF Model = 2.40/22 + 4.8% = 15.71%
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Tabular Representation:
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Part B)
NPV is the difference between the present value of cash inflows and present value of cash outflows. Present value is calculated by discounting future cash flows to today's value with the use of a discount rate. The formula for calculating NPV is:
NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+WACC)^1 + Cash Flow Year 2/(1+WACC)^2 + Cash Flow Year 4/(1+WACC)^3 + Cash Flow Year 4/(1+WACC)^4
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Using the information provided in the question, we get,
Project A's NPV = - 1,080 + 660/(1+9%)^1 + 300/(1+9%)^2 + 290/(1+9%)^3 + 340/(1+9%)^4 = $242.81 or $242.8
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Project B's NPV = - 1,080 + 260/(1+9%)^1 + 235/(1+9%)^2 + 440/(1+9%)^3 + 790/(1+9%)^4 = $255.74 or $255.7
CAPM cost of equity: 11.24% Bond yield plus risk premium: 13.47% DCF cost of equity: 15.71%Related Questions
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