Question

1. a) The market value of the company's debt is USD 400,000. In addition to this, it has equity. Its cost of debt is 6%, cost of equity 11% and weighted average cost of capital (WACC) 8%. The market risk premium is 7%. Assume a corporate tax rate of 0%. What proportion of the market value of the entire company is the market value of equity as a percentage?

Please show your working, the answer is somewhere between 37 and 40%.

b) Stock A has an expected return of 8% and a beta of 0.9. The risk-free interest rate is 2%. Stock B, on the other hand, is 1.3. What is the expected return on stock B? Assume that the expected return for both shares corresponds to the return requirement given by the CAPM. CAPM therefore pricing the shares correctly and the shares can be located on the Security Market Line directly according to their beta and expected return.

Please show your working, the answer is somewhere between 11 to 12%.

c) The company is expected to pay a dividend of USD 5 after one year and USD 8 after two years. In addition, the share price is expected to be USD 24 after two years immediately after the said USD 8 dividend has been paid to shareholders. Investors have set a return requirement of 8% for this share. What is the price at which the net present value of investing in this stock is zero (NPV = 0)?

Please show your working, the answer is somewhere between 29 to 24 USD.

Answer 1

Answer A:

Let weight of equity be x and weight of debt be (1 - x)

WACC = Weight of debt * Cost of debt + Weight of equity * Cost of equity
0.08 = (1 - x) * 0.06 + x * 0.11
0.08 = 0.06 - x * 0.06 + x * 0.11
0.02 = x * 0.05
x = 0.40 or 40%

Weight of Equity = 40%

Answer B:

Stock A:

Expected Return = Risk-free Rate + Beta * Market Risk Premium
0.08 = 0.02 + 0.90 * Market Risk Premium
0.06 = 0.90 * Market Risk Premium
Market Risk Premium = 0.0667

Stock B:

Expected Return = Risk-free Rate + Beta * Market Risk Premium
Expected Return = 0.02 + 1.30 * 0.0667
Expected Return = 0.1067 or 10.67%

Answer C:

Dividend in Year 1, D1 = $5
Dividend in Year 2, D2 = $8
Stock Price in Year2, P2 = $24
Required Return, rs = 8%

Current Price = D1 / (1 + rs) + D2 / (1 + rs)^2 + P2 / (1 + rs)^2
Current Price = $5 / 1.08 + $8 / 1.08^2 + $24 / 1.08^2
Current Price = $32.06