Question

(i) You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

(ii) Company Weaver expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

(iii) What are the three ways to determine the cost of common equity?

Answer 1

Calculations regarding to Altenative 1:

Initial investment = RM 10,000

Cost of capital = 12%

Year	Annual cash inflow(RM)	Discount Cash Factor(12%)	Discounted cash inflow(RM)
1	4,000	0.89285	3,571.40
2	3,000	0.79719	2,391.57
3	3,000	0.71178	2,135.34
4	4,000	0.63551	2,542.04
5	3,000	0.56742	1,702.26
Total	17,000		12,342.61

Year	Annual cumulative cash flow(RM)	Annual discounted cumulative cash flow(RM)
1	4,000	3,571.40
2	7,000	5962.97
3	10,000	8,098.31
4	14,000	10,640.35
5	17,000	12,342.61

i) Payback period = Years before full recovery + (Unrecovered amount of amount / Cash flow during the year)

Payback period = 3+(0/4,000)

Payback period = 3 Years

ii) Discounted payback period = Years before full recovery + (Unrecovered amount of amount / Discounted Cash flow during the year)

ii) Discounted payback period = 3 + {(10,000-8,098.31)/2,542.04}

Discounted payback period = 3 + 0.748

Discounted payback period = 3.748 years

iii) Net present value = Total Discounted cash flow - Intial investment

Net present value = 12,342.61 - 10,000

Net present value = 2,342.61

iv) IRR

Lets Calculate NPV at cost of capital @25%

NPV ={(4,000*0.8)+(3,000*0.64)+(3,000*0.512)+(4,000*0.4096)+(3,000*0.3276)} - 10,000

NPV = 9,277.2-10,000

NPV = -722.80

NPV = 2,342.61 at cost of capital @12%

IRR will be at NPV = 0

IRR = Lower cost of capital rate +{ (Lower rate NPV/Difference between NPV)*Difference between cost of capital)}

IRR = 12 %+{(2,342.61/3065.41)*0.13

IRR = 12 % + 9.9347 %

IRR = 21.9347 %

Calculations regarding to Altenative 2:

Initial investment = RM 10,000

Cost of capital = 12%

Year	Annual cash inflow(RM)	Discount Cash Factor(12%)	Discounted cash inflow(RM)
1	2,000	0.89285	1,785.70
2	3,000	0.79719	2,391.57
3	4,000	0.71178	2,847.12
4	6,000	0.63551	3,813.06
5	6,000	0.56742	3,404.52
Total	21,000		14,241.97

Year	Annual cumulative cash flow(RM)	Annual discounted cumulative cash flow(RM)
1	2,000	1,785.70
2	5,000	4177.27
3	9,000	7024.39
4	15,000	10837.45
5	21,000	14241.97

i) Payback period = Years before full recovery + (Unrecovered amount of amount / Cash flow during the year)

Payback period = 3+(10,000-9,000/6,000)

Payback period = 3.17Years

ii) Discounted payback period = Years before full recovery + (Unrecovered amount of amount / Discounted Cash flow during the year)

ii) Discounted payback period = 3 + {(10,000-7024.39)/3,813.06}

Discounted payback period = 3 + 0.780

Discounted payback period = 3.780 years

iii) Net present value = Total Discounted cash flow - Intial investment

Net present value = 14241.97 - 10,000

Net present value = 4241.97

iv) IRR

Lets Calculate NPV at cost of capital @25%

NPV ={(2,000*0.8)+(3,000*0.64)+(4,000*0.512)+(6,000*0.4096)+(6,000*0.3276)} - 10,000

NPV = 9991.200-10,000

NPV = -8.80

NPV = 4241.97 at cost of capital @12%

IRR will be at NPV = 0

IRR = Lower cost of capital rate +{ (Lower rate NPV/Difference between NPV)*Difference between cost of capital)}

IRR = 12 %+{(4241.97/4250.77)*0.13

IRR = 12 % + 12.973%

IRR = 24.973%

v) Conclusion :

Alternative 2 is the good option having considerable NPV and high IRR even though payback and discounted payback period are longer compare to Alternative 1.