Q-1. (a) The following table gives Foust Company’s earnings per share (EPS) for the last 10 years. The common stock, 7.8 million shares outstanding, is now (1/1/20) selling for $65.00 per share. The expected dividend at the end of the current year (12/31/20) is 55% of the 2019 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.) Foust has 25-year non-callable bonds outstanding with a face value of $1,000, an 12% annual coupon, and a market price of $1,320. Foust can issue perpetual preferred stock at a price of $47.50 a share. The stock would pay a constant annual dividend of $3.80 a share. Its capital structure, considered to be optimal, is as follows: Debt $111,000,000 Preferred Stock $4,000,000 Common equity $155,000,000 Total liabilities and equity $270,000,000 i. If the company was to issue new debt, what would be a reasonable estimate of the interest rate on that debt? ii. If the company’s tax rate is 40%, what is its after-tax cost of debt? iii. Calculate Foust’s cost of common equity by DCF approach? iv. If the firm’s beta is 1.4, the risk-free rate is 7 %, and the average return on the market is 13%, what will be the firm’s cost of common equity using the CAPM approach? v. If the firm’s bonds earn a return calculated in part (i), based on the bond-yield-plus-risk-premium approach, what will be cost of common equity? Use the midpoint of the risk premium range discussed in the class. vi. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Foust’s cost of common equity. vii. What is the company’s cost of preferred stock, rp? viii. Find Foust’s WACC. (use cost of common equity calculated in part vi)
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Q-1.
(a)
The following table gives Foust Company’s earnings per share (EPS) for the last 10 years. The common stock, 7.8 million shares outstanding, is now (1/1/20) selling for $65.00 per share. The expected dividend at the end of the current year (12/31/20) is 55% of the 2019 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.)
Foust has 25-year non-callable bonds outstanding with a face value of $1,000, an 12% annual coupon, and a market price of $1,320. Foust can issue perpetual
Debt $111,000,000
Preferred Stock $4,000,000
Common equity $155,000,000
Total liabilities and equity $270,000,000
i. If the company was to issue new debt, what would be a reasonable estimate of the interest rate on that debt?
ii. If the company’s tax rate is 40%, what is its after-tax cost of debt?
iii. Calculate Foust’s
iv. If the firm’s beta is 1.4, the risk-free rate is 7 %, and the average return on the market is 13%, what will be the firm’s cost of common equity using the
v. If the firm’s bonds earn a return calculated in part (i), based on the bond-yield-plus-risk-premium approach, what will be cost of common equity? Use the midpoint of the risk premium range discussed in the class.
vi. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Foust’s cost of common equity.
vii. What is the company’s cost of preferred stock, rp?
viii. Find Foust’s WACC. (use cost of common equity calculated in part vi)
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