The market interest rate is used for determining the prevailing rates of interest offered on loans or cash deposits as determined by market demand and supply of credit or deposits and is usually based on duration. The higher the duration and amount, the higher the rate. The cost of debt in a financial institution is used in determining the interest that a firm pays on its borrowings (Caks, 1977).
1 B. What is the firms cost of preferred stock?
Nominal dividend rate 10%
Dividends per year 4
Par value $100
The cost of preferred stock is calculated as follows:
Rp =Dp/((Vp(1-fp)) and as per the data, can be simplified to (nominal dividend rate/price)
Vp is 100; Dp is 10
Cost of Preferred Stock =
10/111.10= .09 or 9%
Cost of Preferred Stock= 9%
The Cost of Preferred stock is used in a financial institution to determine the perpetuity that receives a constant dividend payments to shareholders (Daske, 2006).
2 A. What is XYZs estimated cost of common equity using the CAPM approach?
The estimated cost of equity can be calculated as follows:
rs= rRF+ ss ( rM-rRF)
=7 + 1.2*6 = 14.2%
Estimated Cost of Common Equity = 14.2%
2 B. What is the estimated cost of common equity using the DCF approach?
Current dividend $4.19
Constant growth rate 5%
The estimated cost of common equity can be obtained as follows:
rs= (D1/P0) + g
where D1is next years dividend; P0 is price and g is XYZs constant growth rate.
Next years dividend D1 is calculated as = D0 x (1 + g)= 4.19(1+5%)=$4.399
These parameters are provided, and thus, it is calculated as follows:
rs= (D1/P0) + g=($4.399/$50)+5%=0.138 or 13.8%
Estimated Cost of Common Equity = 0.138 or 13.8%
The Estimated Cost of Common Equity is used to compare an investment to other investments with similarity in risk profiles to enable a company select the most viable investment (Daske, 2006).
3. A. What is the bond-yield-plus-risk-premium estimate for XYZs cost of common equity?
"Bond yield + RP" premium 4%
market interest rate on XYZs debt 10%
The Bond-yield-plus-risk-premium estimate can be calculated as follows: rs= rd+ risk premium
Bond-yield-plus-risk-premium estimate = 14%
3 B. What is your final estimate for rs?
rd + RP 14.00%
Can be obtained by averaging CAPM, DCF. and rd + RP.=(14.20+13.8+14)/3=14%
Bond-yield-plus-risk-premium Estimate =14%
As Petravicius and Tamosiuniene (2008) point out, the bond-yield-plus-risk-premium allows a company to determine the value of an asset and allows it to estimate the return on equity via adding the yield to maturity of market interest rate to the equitys risk premium on the firms long-term debt.
4 A. XYZ estimates that if it issues new common stock, the flotation cost will be 15%. XYZ incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost?
% Flotation cost 15%
Net proceeds after flotation $42.50
The Cost of Newly Issued Common Stock is calculated as follows:
re=(((D1/((P0(1-fe))) + g
fe is flotation costs; D1 next years dividends; P0 is price after flotation; Next years dividend D1 is $4.399; g is g is XYZs constant growth rate at 5%.
Re=(((4.399/((42.50(1-15%))) + 5% = 4.399/36.125= 0.05 = 0.172 or 17.2%
Cost of Newly Issued Common Stock = 0.172 or 17.2%
According to Boundless (n.d), the cost of newly issued common stock is used in evaluating a firms new projects by enabling it to decide whether the project is to be financed using a balance between external or internal sources.
4 B. What is XYZs overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
wd 30% rd (1 T) 6.00%
WACC= wd((rd (1 T))+ wprp+wcrsWACC= 30%*6%+10%*9%+60%*14% =0.018+0.009+0.084 = 0.111 or 11.1%
WACC= 0.111 or 11.1%
A financial institution uses WACC to determine the average rate of return after tax it expects so that it can determine how and whether different investors will be compensated (Arnold & Crack, 2004).
Arnold, T., & Crack, T. F. (2004). Using the WACC to value real options.Financial Analysts Journal, 60(6), 78-82.
Boundless (n.d). The Cost of New Common Stock. Boundless. Retrieved from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/valuing-different-costs-88/the-cost-of-new-common-stock-379-3902/
Caks, J. (1977). The coupon effect on yield to maturity. The Journal of Finance, 32(1), 103-115.
Daske, H. (2006). Economic Benefits of Adopting IFRS or USGAAPHave the Expected Cost of Equity Capital Really Decreased?. Journal of Business Finance & Accounting, 33(34), 329-373.
Petravicius, T., & Tamosiuniene, R. (2008). Corporate performance and the measures of value added. Transport, 23(3), 194-201.
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