Essay on Case 15

The next step was to determine the cost of debt and cost of equity. Case assumptions made by Liedtke of a 40% corporate tax rate, 6% estimated cost of debt, and 20% leverage were used in calculating the cost of debt. The cost of debt was determined to be 3.6% (= Debt*(1-Tax Rate).

To relever the βe, we use the formula, βe = βu +(D/E)*(βu-βd). And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new βe, 1.3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+β(EMRP), 11.7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8.48%.

9. What is the Cost of Debt, before and after taxes? Using the interest rate for the largest debt…cannot use the weighted interest rate for the debt since it includes capital lease obligations with no stated rate and could not find in the notes to the financials. 5.4% After tax cost is .054 x (1-.36) = 3.5%

Company sells 500 bonds for $1,000 to raise $500,000 in capital with 6% return (cost of debt)

Based upon a weighted average cost of capital, the issuance of preferred shares yields an overall, after tax, price of 3.587%. The underlying assumption is that the common shares continue to receive an annual dividend of .23, yield of 4.15%. The alternate consideration of issuing unsecured bonds costs the bank 3.721% for the capital.

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Guillermo and other financial managers should be aware, however, that the stockholders may become negatively impacted if the capital cost goes down. To remain current, move towards the high-tech alternative or to move towards the broker solution, Guillermo has calculated that the IRR would be 6.9%, 64.7% and 11% respectively.

Rollin’s Corporation has a before- tax cost of debt of 12%, its beta is 1.2, the risk- free rate is 10 percent, and the market return is 15 percent. The marginal tax rate of the company is 40%. What is the cost of debt for Rollin’s

The  current T.bill rate is 3%. (It was 5% one year ago).The stock is currently selling  for $50, down $4 over the last year, and has paid a dividend of $2 during the  last year and expects to pay a dividend of $2.50 over the next year. The New  York Stock Exchange (NYSE) composite has gone down 8% over the last year,  with a dividend yield of 3%. HeavyTech Inc. has a tax rate of 40%.    a. What is the expected return on HeavyTech over the next year?  b. What would you expect HeavyTech’s price to be one year from today?   c. What would you have expected HeavyTech’s stock returns to be over  the last year?    d. What were the actual returns on HeavyTech over the last year?   e. HeavyTech has $100 million in equity and $50 million in debt. It plans  to  issue  $50  million  in  new  equity  and  retire  $50  million  in  debt.   Estimate the new beta.  a. Using the CAPM, we compute the expected return as 0.03 + 1.2(0.0792) = 12.5%.  We use a T‐bill rate, because the focus is on the short‐term expected return (the  next year). For the same reason, we use the market premium over bills.    b. The cum‐dividend price, one year from now, would be $50 *(1 + 12.50%) = $56.25.  The ex dividend price, assuming that the stock price goes down by the amount of  the dividend is $56.25– $2.50 = $53.75.    c. Over last year, the expected return would have been 0.05+1.2*0.0792=14.5%.

Teletech’s current hurdle rate of 9.30% is based on an estimate of the company’s weighted average cost of capital. It is applied to all capital projects and used as a tool for performance evaluation by top management at the firm, regardless of which of the company’s two business units it is applied towards.

In order to calculate the cost of capital for the contract service division I will use most of the formulas

$2,500 $5,000 MV of equity $10,000 $8,350 $6,700 Pretax cost of debt 0.07 0.07 0.07 After-tax cost of debt 0.0462 0.0462 0.0462 Market Weight of Debt 0 0.23 0.43 Market Weight of Equity 1.0 0.77 0.57 Un-levered Beta 0.8 0.8 0.8 Risk free rate 0.07 0.07 0.07 Market premium 0.086 0.086 0.086 Cost of equity 13.88% 15.4% 20.8% WACC 13.88% 13.5% 13.8% EBIT $2,103 $2,103 $2,103 - Taxes - 34% $1,388 $1,388

c)If the firm belongs to an industry whose average asset turnover is 3, does it have a