Sweetums Manufacturing (SM) Inc. has 3 million shares of common stock and 150,00
ID: 2786658 • Letter: S
Question
Sweetums Manufacturing (SM) Inc. has 3 million shares of common stock and 150,000 bonds outstanding. SM just paid a dividend of $3 per share and expect this dividend to grow 2% for the foreseeable future. The beta on this stock is 1.7, U.S treasury bills are yielding 1%, and the expected return on the market is 9%. SM bonds have 10 years to maturity, pay a 7% coupon, and currently sell at 116 percent of par value. The firm has an average tax rate of 25%. What is the company's discount rate?
THE ANSWER IS 6.9%. But I dont know how they got the answer. Please answer in a simple way. Thanks
Explanation / Answer
Cost of equity = Risk free rate + Beta * (Market return - risk free rate)
Cost of equity = 1% + 1.7*(9% - 1%) = 14.6%
Cost of debt = RATE(10,7%*1000,-1160,1000) = 4.93%
Share price= Dividend*(1+growth) / (Cost of equity - growth)
Price = 3*(1+2%)/(14.6% - 2%) = 24.29
Value of equity = 3 * 24.29 = 72.86 million
Value of debt = 150000 * 1160 = 174 million
We = 72.86 / (72.86 + 174) = 29.51%
Wd = 1 - We = 1 - 29.51% = 70.49%
Discount rate = Wd*Rd*(1-tax rate) + We*Re
= 70.49%*4.93%*(1-25%) +29.51%*14.6%
= 6.92%
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