Question

1. Biogenetics Corporation has a target capital structure of 60 % common stock and the rest on bonds. The risk-free rate is 5%, and the return on the stock market is 15%. This year, Biogenetics bonds had a YTM of 5.5%, and the company is on the 35 percent tax bracket. On last trading day, Biogenetics paid dividends of $3/share , which will grow at 3% every year. Last trading day the stock was selling at $30. The company beta is 1.5. a. Compute the return on the equity (Re) using the Dividend Growth Model (DGM), and the Security Market Line (SML). Show Calculation (10 points) c. The company president has approached you about the company capital structure. He wants to know why the company doesn’t use more stock financing since it costs less than debt. What would you tell the president? (5 points)

Answer 1

last trading day price of stock , p0 = $30

last dividend psid , d0 = 3

growth rate of dividend , g = 3% = 0.03

dividend expected next year , d1 = d0*(1+g) = 3*1.03 = $3.09

according to DGM,

return on equity = (d1/p0) + g = (3.09/30) + 0.03 = 0.133 or 13.3%

company beta , b = 1.5

return on stock market . rm = 15% = 0.15

risk free rate , rf = 5% = 0.05

as per SML

return on equity = rf + [b*(rm - rf)] = 5 + [ 1.5*(15-5)] = 5 + 15 = 20%

c) tax rate for company , t = 35% = 0.35

YTM = 5.5%

after tax cost of debt , d = YTM*(1-t) = 5.5*(1-0.35) = 3.575% or 3.58% ( rounding off to 2 decimal places)

the company doesn't use more stock financing because as we have seen from the above calculations , from both the methods , the return on equity or the cost of equity is greater than the after tax cost of debt.