Question

Scanlin, Inc. is considering a project that will result in initial aftertax cash savings of $2.1 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debut-equity ratio of 1.00, a cost of debt of 9.6 percent, and a beta of 1.50. The cost-saving proposal is closely related to the firm’s core business, so it is viewed as having the same risk as the overall firm. Assume a 34 percent tax rate, return on the market of8 percent, and the riskless return of 2 percent.

Q4. The firm’s most recent dividend was $2.05 per share, and dividends are expected grow at an annual rate of 4.1 percent indefinitely. How much should the firm’s price per share be? Round your answer to two decimal places.

Q5. Suppose Cougar Gold Inc., Scanlin’s biggest competitor, has 400,000 shares of preferred stock outstanding with $3.65 stated dividend. What is Cougar Gold’s preferred stock price if the next dividend is in exactly 7 months and the discount rate of 4.2%? Round your answer to two decimal places.

Answer 1

4. We will first find the WACC of Scanlin

Cost of Debt = 9.6%

After tax cost of debt = 9.6% x (1- Tax Rate)

= 9.60% X (1-34%) = 6.34%

Cost of Equity

We will use CAPM to calculate the cost of equity

Expected Return (on Equity) = Rf + Beta x (Rm - Rf)

where Rf = Risk free rate of interest

Rm = Market return

Beta = Stock beta

Cost of Equity = 2% + 1.5 x (8% - 2%)

= 2% + 1.5 x 6%

= 11%

The Debt/ Equity ratio is 1, which means Weight of Debt = 50%, Weight of Equity = 50%

Weighted Average Cost of Capital = 50% x 6.34% + 50% x 11%

= 8.67%

Price of share = D0 x (1+g) / (k -g)

where, D0 = Current year dividend (2.05)

g = Long period growth rate (4.1%)

k = Cost of capital (WACC) (8.67%)  

Price of share =  2.05 x (1+ 4.1%) / (8.67% - 4.1%)

= $46.72

5. The price of Preferred stock after 7 months = Dividend/ Discount Rate

= 3.65/ 4.2%

= $ 86.90

Time for next dividend = 7 months = 7/12 years.

The current price would be a discounted value of Preferred stock using t = 7/12 & rate = 4.20%

The Price of Preferred stock now = $86.90 / (1+4.20%)^ (7/12)

= $84.84