Question

Suppose stock in Warren Corporation has a beta of 0.90. The market risk premium is 6 percent, and the risk-free rate is 6 percent. Warren’s last dividend was €1.20 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for €45 per share. Warren has a target debt-equity ratio of 0.50. Its cost of debt is 9 percent before taxes. Its tax rate is 21 percent.

Instructions:

a. What is Warren’s cost of equity capital? Assume that you equally believe in the CAPM approach and the dividend growth model. (5 points)

b. What is Warren’s WACC? (5 points)

c. Warren is seeking €30 million for a new project. The necessary funds will have to be raised externally. Warren’s flotation costs for selling debt and equity are 2 percent and 16 percent, respectively. If flotation costs are considered, what is the true cost of the new project? (10 points)

d. Under what circumstances would it be appropriate for Warren Corporation to use different costs of capital for its different operating divisions? What are two techniques you could use to develop a rough estimate for each division’s cost of capital? (10 points)

Answer 1

a.Cost of Equity Capital:

CAPM Equation

Rs=Rf+Beta*(Rm-Rf)

Rs=Required Return on Stock

Rf=Risk Free Rate=6%

Beta=0.9

Rm-Rf=Market Risk Premium =6%

Rs=6+0.9*6=11.4%

Cost of Equity =11.4%

Dividend Growth Model:

D0=Last Dividend=1.2

g=growth rate=8%=0.08

D1=Next Years dividend =D0*(1+g)=1.2*1.08=1.296

P0=Current Price =45

Required Return =R=(D1/P0)+g=(1.296/45)+0.08=0.1088=10.88%

Cost of Equity =10.88%

EXPECTED COST OF EQUITY =0.5*11.4%+0.5*10.88%=11.14%

b. WACC

After tax cost of debt=9%*(1-Tax rate)=9%*(1-0.21)=7.11%

Debt Equity Ratio=0.5

Debt=0.5*Equity

Total capital=0.5*Equity+Equity=1.5*Equity

Weight of Debt =0.5/1.5=0.3333

Weight of Equity =1/1.5=0.6667

WACC=Weightof Debt*Cost of Debt+Weightof Equity*Cost of Equity

WACC=0.3333*7.11%+0.6667*11.14%=9.80%

c.Cost of New Project:

Cost of Debt=7.11%/(1-flotation cost)=7.11/(1-0.02)=7.26%

Cost of Equity =11.14/(1-0.16)=13.26%

WACC of new project=0.3333*7.26+0.6667*13.26=11.26%

d. Different cost of capital should be used for different divisions, if the risk of projects are different .

Risk adjusted cost of capital may be used