Use the following information about SV Inc. to calculate the company’s Cost of Capital. The stock of SV Inc. sells for $50, and last year’s dividend was $2.10. A flotation cost of 10% would be required to issue new common stock. SVs’ preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 7% a year. The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 35%. The market risk premium is 6%, the risk-free rate is 6.5%, and Supreme Ventures’ beta is 0.83. In its cost-of-capital calculations, SV Inc. uses a target capital structure with 45% debt, 5% preferred stock, and 50% common equity. REQUIRED: Section A Calculate the cost of each capital component: the after-tax cost of debt the cost of preferred stock (including flotation costs) the cost of equity (ignoring flotation costs). Use both the DCF(DGM) method and the CAPM method to find the cost of equity. Section B i.Calculate the cost of new stock using the DCF(DGM) model. ii. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the DCF(DGM) method and then add that difference to the CAPM value for rs.) iii. Assuming that SV will not issue new equity and will continue to use the same target capital structure, what is the company’s WACC? SECTION C Suppose SV Inc. is evaluating three projects with the following characteristics: i. Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from reinvested earnings. ii. Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0%. iii. Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%. iv. Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%. Analyze the company’s situation and explain why each project should be accepted or rejected. PLEASE START FROM SECTION B
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
PLEASE START FROM SECTION B
Use the following information about SV Inc. to calculate the company’s Cost of Capital.
- The stock of SV Inc. sells for $50, and last year’s dividend was $2.10.
- A flotation cost of 10% would be required to issue new common stock.
- SVs’
preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share. - Security analysts are projecting that the common dividend will grow at a rate of 7% a year.
- The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 35%. The market risk premium is 6%, the risk-free rate is 6.5%, and Supreme Ventures’ beta is 0.83.
- In its cost-of-capital calculations, SV Inc. uses a target capital structure with 45% debt, 5% preferred stock, and 50% common equity.
REQUIRED:
Section A
Calculate the cost of each capital component:
-
- the after-tax cost of debt
- the cost of preferred stock (including flotation costs)
- the
cost of equity (ignoring flotation costs).
Use both the DCF(DGM) method and the
Section B
i.Calculate the cost of new stock using the DCF(DGM) model.
ii. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the DCF(DGM) method and then add that difference to the CAPM value for rs.)
iii. Assuming that SV will not issue new equity and will continue to use the same target capital structure, what is the company’s WACC?
SECTION C
Suppose SV Inc. is evaluating three projects with the following characteristics:
i. Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from reinvested earnings.
ii. Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0%.
iii. Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%.
iv. Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%.
Analyze the company’s situation and explain why each project should be accepted or rejected.
PLEASE START FROM SECTION B
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