Question

Suppose stock in Warren Corporation has a beta of 0.80. 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:

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

2. What is Warren’s WACC? (5 points)

3. 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)

4. 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

Suppose stock in Warren Corporation has a beta of 0.80. 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?

.

Under CAPM model

Cost of equity = Rf + beta * market risk premium

Cost of equity = 6% + 0.8 * 6%

Cost of equity = 6% + 4.8 = 10.8%

.

.Under the dividend growth model

Formula is

Cost of equity = D1 / M + G

Where,

D1 = next ( estimated ) year dividend = last year dividend * ( 1 + growth rate ) = 1.2 * ( 1 + 8% ) = 1.296

M = .The stock currently sells for €45 per share\

G = growth rate = 8%

.

Cost of equity = 1.296 / 45 + 0.08

Cost of equity = 0.0288 + 0.08 = 0.1088 or 10.88%

.

Cost of equity equally weighted

Cost of equity = (0.50 * 10.8 ) + ( 0.50 * 10.88 ) = 10.84%

.

B. What is Warren’s WACC?

.

WACC = ( cost of equity * weight ) + ( cost of debt * weight )

Where,

cost of equity = 10.84%

cost of debt = before tax cost of debt * ( 1 - tax rate )

cost of debt = 9% * ( 1 - 21% )

cost of debt = 9% * 0.79 = 7.11%

.

Weight of each components is calculate using debt-equity ratio of 0.50

Which meant, debt is 1/2 of equity

If equity = 1

Debt = 0.50

Weight of each items

Equity = 1 / 1.5 = 0.67

Debt = 0.50 / 1.5 = 0.33

.

WACC = ( 10.84% * 0.67 ) + ( 7.11% * 0.33 )

WACC = 7.2628 + 2.3463

WACC = 9.61%

.

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?

.

Cost of equity = D1 / (M - F ) + G

M - F = Selling price - flotation cost = 45 - 16% = 37.8

New Cost of equity = 1.296 / 37.8 + 0.08

New Cost of equity = 0.03428 + 0.08

New Cost of equity = 0.1143 or 11.43%

.

New cost of debt = ( Before tax cost * ( 1 - tax rate ) / 98%

New cost of debt = ( 9% * 0.79 ) / 98%

New cost of debt = 7.11% / 98% = 7.26%

.

WACC = ( 11.43% * 0.67 ) + ( 7.26% * 0.33 )

WACC = 7.6581 + 2.3958 = 10.05%

.

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?

.

use different costs of capital for its different operating divisions

1. If new project has risk in relation to another existing project or firm, it is known as firm risk, in this situation we need to use different cost of capital

2. Such new project has risk in relation to market or economy, known as market risk. In this situation we need to use different cost of capital.

.

two techniques you could use to develop a rough estimate for each division’s cost of capital

1. Risk adjusted discount rate method:- under this method different risk premium is assigned to different project based on risk.

2. Capital asset pricing model: under this method for different project use different beta of assets