Question

A corporation has 9,000,000 shares of stock outstanding at a price of $40 per share. They just paid a dividend of $2 and the dividend is expected to grow by 5% per year forever. The stock has a beta of .9, the current risk free rate is 4%, and the market risk premium is 6%. The corporation also has 300,000 bonds outstanding with a price of $1,100 per bond. The bond has a coupon rate of 8% with semiannual interest payments, a face value of $1,000, and 13 years to go until maturity. The company plans on adding debt until they reach their target debt ratio of 70%. They expect their cost of debt to be 9% and their cost of equity to be 14% under this new capital structure. The tax rate is 25% 1. What is the required return on the corporation’s stock? a) 9.4% b) 10.25% c) 11.3% d) 12.2% 2. What is the expected return on the corporation’s stock? a) 9.4% b) 10.25% c) 11.3% d) 12.2% 3. What is the yield to maturity on the company’s debt? a) 6.2% b) 6.5% c) 6.8% d) 7.1%

Answer 1

a) Option b) 10.25% is correct
Calculation of Required Rate of Return
Dividend Growth Model
Price	40
D0	2
g	5%
Ke=(D0*(1+g)/p0)+g=(2*(1+5%)/40)+5%			10.25%
b) Option a) 9.4% is correct
Calculation of Expected Rate of Return
CAPM Method
beta	0.9
rf	4%
Rp	6%
Ke=rf+beta*(Rp)=4%+.9*(6%)			9.40%
c) Option c) 6.8% is correct
Method to calculate apptoximate cost of Debt =(C+(F-P)/n)/((F+P)/2)
Where
C= Coupon/Interest Payment=8/2=4
F=Face value=1000
P=Price=1100
n=no of periods=13*2=26
cost of Debt =(40+(1000-1100)/26)/((1000+1100)/2)			0.034432	or	3.44%
Annual Cost of Debt=3.44%*2					6.88%