Question

Saturn Corporation uses both equity and debt financing. They are able to borrow any
amount at 9% interest rate as long as they finance their target capital structure, which is
40% debt and 60% equity. The last dividend they paid to their shareholders was $3 (D1)
and the financial analyst expected the constant growth rate is 5%. The Saturn stock is
selling at a price of $22. The marginal tax applied is 40%. Saturn has two project
proposals.
Project X rate of return is 13% and Project Y rate of return is 14%. All company’s
projects are equally risky.

a) Calculate the cost of equity and total cost of capital
b) Which project Sanders Corp. should select? Why?

Answer 1

a)

Cost of equity under CAPM :-[ D0 * ( 1+g) / market price ] + g

D0 = dividend paid = 3

g = growth rate = 5%

market price = 22

cost of equity =[ 3 * (1+0.05) / 22] + 0.05 = 3.15 / 22 + 0.05 = 0.14318 + 0.05

cost of equity = 19.3182%

Cost of debt after tax = interest rate * ( 1 - tax rate) = 9% * ( 1 - 0.40) = 5.4%

Cost of capital = Cost of debt after tax * weight of debt + cost of equity * weight of equity

= 5.4% * 0.40 + 19.3182% * 0.60

cost of capital = 13.7509%

b) Project Y is selected

Reason :-

Here Cost of capital is 13.7509%

return on project X = 13%

return on project Y = 14%

Project X is not selected because return on project X is lower than Cost of capital ( 13%< 13.7509%)

Project Y is selected because of return on project Y is higher than cost of capital ( 14%> 13.7509%)