Question

Casper's Inc. just paid $1.5 dividend per share, and expects that the annual growth rate of dividend per share in the future will be 10%. The firm has 60,000 shares of common stock outstanding at a market price of $49 per share, and the stock’s beta is 1.26. The firm has 9,800 shares of 12.24% preferred stock with a market value of $100 a share. The firm has $1,100,000 outstanding bonds with the yield-to-maturity rate at 8.75%. The corporate tax rate is 33%. The risk-free rate is 3.2% and the market risk premium is 9.1%. Please answer the following questions:

a) What should be the cost of equity for the firm if using the Dividend Growth Model? What should be the cost of equity for the firm if using the CAPM (i.e., SML)? Then, based on the average of these two estimates, what is the cost of equity for the firm?

b) Please calculate the weighted average cost of capital (WACC) for the firm. Assume the cost of equity is equal to the average of two estimates calculated in part (a).

Answer 1

	a)	COST OF EQUITY
		AS per Dividend Growth Model
		D0=Current Dividend	$1.50
		g=dividend growth rate	10.0%	0.1
		P0=Current market Price =$49
		Next years Dividend =D1=1.5*1.1	$1.65
		Cost of Equity =(D1/P0)+g=(1.65/49)+0.1	13.4%
		Cost of Equity as per CAPM Equation
		Cost of Equity=Rf+Beta*(Rm-Rf)
		Rf=Risk free rate =3.2%
		Beta=1.26,
		Rm-Rf=Market Risk Premium=9.1%
		Cost of Equity =3.2+1.26*9.1=	14.7%
		Average of the two methods=(13.4+14.7)/2	14.0%
	Ce	Cost of Equity	14.0%
	b)	WEIGHTED AVERAGE COST OF CAPITAL
		Market Value of Capital Structure
	Md	Market Value of Debt	$1,100,000
	Mp	Market Value of Preference shares	$980,000	(9800*$100)
	Me	Market value of Common Equity	$2,940,000	(60000*49)
	M=Md+Mp+Me	Total Market value of Capital	$5,020,000
	Wd=Md/M	Weight of Debt	0.2191
	Wp=Mp/M	Weight of Preferred Stock	0.1952
	We=Me/M	Weight of Equity	0.5857
	Cd	Cost of Debt =Yield*(1-Tax Rate)=8.75*(1-0.33)	5.9%
	Cp	Cost of Preference Shares=	12.24%
	Cd	Cost of Common Equity=	14.0%
		Weighted Average Cost of Capital (WACC)=Wd*Cd+We*Ce+Wp*Cp
	Weighted Average Cost of Capital (WACC)=0.2191*5.9+0.5857*14.0+0.1952*12.24
		WACC=	11.88%