Question

1. Although Santona Osmann has some short‐term debt, you know that the company does not use short‐term interest‐bearing debt on a permanent basis but long‐term debt. You have been informed that the current price of Santona Osmann’s 9% annual coupon payment, noncallable bonds with 20 years remaining to maturity is $1,211.88, with a face value of $1,000.00. New bonds would be privately placed with no flotation cost.
2. The firm's marginal tax rate is 35%.
3. The current price of preferred stocks is $116.95, with annual dividends of 9% of par value,

paid quarterly. The preferred stocks’ par value is $80. The company would incur flotation costs equal to 5% of the proceeds on a new issue. Assume that in the estimations of the cost of preferred stocks, the company uses the effective cost of preferred stocks.

4. According to the most recent information, the company’s stock is currently selling at $40 per share. Its last dividend (D0) was $2.88. The earnings, dividends, and share price of Santona Osmann are expected to grow at 5.5% per year in the future. Additionally, you have been informed that the company’s stock is 10% more volatile than the average stock in the market; the yield on Treasury‐bonds is 1.8%; and the estimated market risk premium is 7%. Regarding the estimation of the cost of common equity, given the high volatility in the capital markets, the company has decided to compute it as the average between the estimations based on the Discounted Dividend Model (DDM) and the Capital Asset Pricing Model (CAPM).
5. Regarding the capital structure of the company, you checked out the Balance Sheet and discovered that Santona Osmann has $320 (million) in common equity, and that the total outstanding debt is exactly 2.5 times greater that the common equity, whilst the preferred stocks represent three‐fifths of the company’s common equity.

What is the estimated cost of common equity using the Discounted Dividend Model (DDM)? And the estimated cost using the Capital Asset Pricing Model (CAPM)?

Answer 1

estimated cost of common equity using the Discounted Dividend Model (DDM)

cost of common equity = [Last dividend*(1+dividend growth rate)/current price of stock] + dividend growth rate

cost of common equity = [$2.88*(1+0.055)/$40] + 0.055 = [($2.88*1.055)/$40) + 0.055 = ($3.0384‬/$40) + 0.055 = 0.07596‬ + 0.055 = 0.13096 or 13.096‬ rounded off to 13.10%

estimated cost using the Capital Asset Pricing Model

cost of common equity = risk-free rate or yield on treasury bonds + stock's beta*estimated market risk premium

stock's beta here is 10% more volatility than the average stock on the market. so estimated market risk premium will be increased by 10% to accommodate this 10% more volatility.

cost of common equity = 1.8% + 7%*(1+10% more volatility) = 1.8% + 7%*(1+0.10) = 1.8% + 7%*1.1 = 1.8% + 7.7‬% = 9.5‬%