Under what situations would you want to use the CAPM approach for estimating the
ID: 2744984 • Letter: U
Question
Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The constant-growth model?
Cost of Equity JaiLai Cos. stock has a beta of 1.2, the current risk-free rate is 4.2 percent, and the expected return on the market is 12 percent. What is JaiLai’s cost of equity?
Cost of Debt Katy Did Clothes has a $250 million (face value) 30-year bond issue selling for 103 percent of par that carries a coupon rate of 7.95 percent, paid semiannually. What would be Katy did’s before-tax component cost of debt?
Cost of Preferred Stock Marme, Inc. has preferred stock selling for 97.5 percent of par that pays an 8 percent annual coupon. What would be Marme’s component cost of preferred?
WACC Suppose that JB Cos. has a capital structure of 75 percent equity, 25 percent debt, and that its before-tax cost of debt is 9 percent while its cost of equity is 15 percent. If the appropriate weighted average tax rate is 30 percent, what will be JB’s WACC?
Explanation / Answer
1) Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The constant-growth model?
Ans:You would want to use the CAPM when you can estimate firm's beta with a good deal of certainity; you would only want to use constant-growth model if the firm's stock is expected experience constant dividend growth.
2)Cost of Equity JaiLai Cos. stock has a beta of 1.2, the current risk-free rate is 4.2 percent, and the expected return on the market is 12 percent. What is JaiLai’s cost of equity?
Using CAPM Model Cost of Equity = Rf + Beta(Rm-Rf) = 4.2% +1.2(12%-4.2%) =13.56%
3)Cost of Debt Katy Did Clothes has a $250 million (face value) 30-year bond issue selling for 103 percent of par that carries a coupon rate of 7.95 percent, paid semiannually. What would be Katy did’s before-tax component cost of debt?
PV= -$1030,FV=$1000,n=60,PMT= $39.75
Using RATE Function in Excell we can find i = 3.85%*2 = 7.7%
4)Cost of Preferred Stock Marme, Inc. has preferred stock selling for 97.5 percent of par that pays an 8 percent annual coupon. What would be Marme’s component cost of preferred?
Kp= $8/$97.5*100 = 8.20%
5) WACC Suppose that JB Cos. has a capital structure of 75 percent equity, 25 percent debt, and that its before-tax cost of debt is 9 percent while its cost of equity is 15 percent. If the appropriate weighted average tax rate is 30 percent, what will be JB’s WACC?
WACC= KE*WE +KDWD(1-Tax)
= 0.75*0.15 + 0.25*0.09(1-0.3)
= 0.12825 or 12.825%
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