Question

Consider a company with the following financial statement information:

                                  Balance Sheet

Cash $140,000                                            Accounts payable $200,000

Marketable securities 200,000                       Wages payable 100,000

Accounts receivable 40,000                            Short-term debt 250,000

Inventory 1,000,000                                        Long-term debt 690,000

Fixed assets 900,000                                    Total liabilities $1,240,000

                                                                    Common stock 950,000                                  

                                                                    Retained earnings 90,000

Total assets $2,280,000                                 Total equity & liabilities $2,280,000

Income Statement

Sales $1,200,000

Cost of goods sold $400,000

Amortization $90,000

Interest $56,400

Earnings before taxes $653,600

Taxes $261,440

Net income $392,160

Shares outstanding 300,000

A. What is the cost of equity given a risk-free rate of 5 percent, a beta of 1.2, and an expected market return of 10 percent?

B. What is the market price and market-to-book ratio, assuming the company’s stock is a perpetuity and the retention ratio is zero?

C. What is the invested capital and before-tax return on investment for this company?

Answer 1

a) Using CAPM, cost of equity, r = Rf + beta x (Rm - Rf) = 5% + 1.2 x (10% - 5%) = 11%

b) With zero retention ratio, dividend = net income = 392,160

Market Value = Net Income / Cost of equity = 392,160 / 11% = $3,565,091

Market to book value = 3,565,091 / (950,000 + 90,000) = 3.43

c) Invested Capital = Total Assets - Cash - Market. Sec. = 2,280,000 - 140,000 - 200,000 = 1,940,000

Before-tax return on investment = (Net Income + Tax) / Invested Capital = (392,160 + 261,440) / 1,940,000 = 33.69%