Question

1. Currently, the XYZ firm has a share price of $20. Next year, the firm is expected to pay a $1 dividend per share. After that, the dividends will grow at 4 percent per year.

1. What is an estimate of the firm’s cost of equity?
2. The firm also has preferred stock outstanding that pays a $2 per share fixed dividend. If this stock is currently priced at $28, what is firm’s cost of preferred stock?
3. The company has an existing debt issued three years ago with a coupon rate of 6%. The firm just issued new debt at par with a coupon rate of 6.5%. What is the pretax cost of debt of the company?
4. The company has 5 million common shares outstanding and 1 million preferred shares outstanding, and its equity has a total book value of $50 million. Its liabilities have a market value of $20 million. If firm’s common and preferred shares are priced as in parts (a) and (b), what is the market value of the firm’s assets?
5. The company faces a 35% tax rate. Given the information in parts (a) through (d), and your answers to those problems, what is XYZ’s WACC?

2.You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $21 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $4.8 million. Investors are willing to provide you with $4.8 million in initial capital in exchange for 40% of the unlevered equity in the firm.

1. What is the total market value of the firm without leverage?
2. Suppose you borrow $0.4 million. According to MM, what fraction of the firm’s equity must you sell to raise the additional $4.4 million you need?
3. What is the value of your share of the firm’s equity in cases (a) and (b)?

Answer 1