Question

1. Bay Inc. just paid its first annual dividend of $0.60 a share. The firm plans to increase the dividend by 3 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $12 a share?

   		7.94 percent
   		9.16 percent
   		6.11 percent
   		8.15 percent

QUESTION 19

1. Eucalyptus Company is financed by $4 million in debt, $1 million in preferred stocks, and $5 million in common stocks. The pre-tax cost of debt is 6%, the cost of preferred stock is 8%, and the cost of equity is 14%. Calculate the weighted average cost of capital. Assume 20% tax rate.

   		9.72%
   		6.29%
   		7.26%
   		8.60%

Answer 1

Solution:

Calculation of Cost of equity of Bay Inc.:

As per the Gordon growth model the price of a stock can be calculated using the following formula:

P₀ = [ D₀ * ( 1 + g ) ] / ( K_e – g )

Where,

P₀ = Current Price of the stock    ;    D₀ = First Annual Dividend Payment   ;

K_e = Cost of equity    ;   g = growth rate

As per the information given in the question we have

P₀ = $ 12    ;   D₀ = $ 0.60   ;    g = 3 % = 0.03   ; K_e = To find

Applying the above values in the formula we have

12 = [ 0.60 * ( 1 + 0.03 ) ] / ( K_e – 0.03 )

12 = ( 0.60 * 1.03 ) / ( K_e – 0.03 )

12 = 0.6180 / ( K_e – 0.03 )

12 * ( K_e – 0.03 ) = 0.6180

( K_e – 0.03 ) = 0.6180 / 12

(K_e – 0.03 ) = 0.0515

K_e = 0.03 + 0.0515

K_e = 0.0815

K_e = 8.15 %

Thus the Cost of Equity of Bay Inc. is = 8.15 %

The solution is Option 4 = 8.15 percent

Solution 19 :        

Calculation of weighted average cost of capital of Eucalyptus  Company :

As per the information given in the question

Value of debt = $ 4 Million                              

Value of Preferred Stocks = $ 1 Million      

Value of Common Stocks = $ 5 Million       

Total Market value of the Securities = $ 4 Million + $ 1 Million + $ 5 Million = $ 10 Million

Thus Weight of Debt = [ Value of debt / Total Value of all the securities ]

= $ 4 Million / $ 10 Million = 0.40

Thus Weight of Preferred Stocks = [ Value of Preferred Stocks / Total Value of all the securities ]

= $ 1 Million / $ 10 Million = 0.10

Thus Weight of Common Stocks = [ Value of Common Stocks / Total Value of all the securities ]

= $ 5 Million / $ 10 Million = 0.50

The formula for calculating the weighted average cost of capital is =

WACC = [ K_D * ( 1 – t ) * W_D ] + [ K_P * W_P ] + [ K_E * W_E ]

K_D = Pre Tax cost of debt    ; t = Income tax rate ; W_D = Weight of debt ;

K_P = Cost of Preferred Stock ; W_P = Weight of preferred stock    ;  

K_E = Cost of Equity    ;    W_E = Weight of common stock or Equity

As per the information available in the question we have

K_D= 6 %     ;   t = 20 % = 0.20 ;   W_D = 0.40 ;

K_P = 8 % ;    W_P = 0.10     ;   K_E = 14 %    ;    W_E = 0.50

Applying the above values in the formula we have

= [ ( 6 % * ( 1 – 0.20 ) * 0.40 ) + ( 8 % * 0.10 ) + ( 14 % * 0.50 ) ]

= [ ( 6 % * 0.80 * 0.40 ) + 0.8 % + 7 % ]

= [ 1.92 % + 0.8 % + 7 % ]

= 9.72 %

Thus the weighted average cost of capital of Eucalyptus  Company is 9.72 %

The solution is Option 1 = 9.72 %