Question

assume the total market value of Firm A consists of the following securities:

Common stock: Price=$48, div(t=0)=$2.25, g=3%.

100m shares outstanding

Preferred stock: Price=$80, perpetual annual dividend=$6.50.

2.5m shares outstanding

Bonds: Price=$1000, YTM=7% (semiannual coupons), Par=$1000, 13 years until maturity.

5m bonds outstanding

1. Use the DCF approach to calculate the cost of common equity. Ignore flotation costs.

2. Express your answer as a percentage. Enter "12.43" for 12.43%. Round to two decimal places if necessary.

3. Calculate the component cost of preferred stock. Ignore flotation costs.

Assuming a tax rate of 40%, calculate the after-tax component cost of debt.

4. Calculate Firm A’s WACC. Assume the firm is currently operating at its target capital structure (in this case, market weights = target weights).

5. Assume Firm B’s FCFs are as follows: Year 1: $120m, Year 2: $200m, and g=4% after Year 2. WACC=7%. Use the Corporate Valuation Model to calculate Firm B’s total market value. Ignore flotation costs.

Answer 1

Solution:

a) D0 = 2.25 , g = 3% ...... D1 = 2.25 *(1.03) = 2.3175

Cost of equity r = g + D1/P = 3% + 2.3175/48 = 7.83%

b) Cost of preferred Stock = D/P = 6.50/80 = 8.13%

c) After tax cost of debt = 7%*(1-40%) = 4.20%

e)

Market Values

Shares =100*48 = 4800

Preferred Stock =2.5*80 = 200

Bond = 5*1000 = 5000

	Market Value	Weights	Post Tax Cost	W * Post Tax Cost
Shares	4800	0.48	7.83	3.76
Preferred Stock	200	0.02	8.13	0.16
Bond	5000	0.5	4.2	2.10
	10000			6.02

WACC = 6.02%

5)

Year 1 = 120

Year 2 = 200

Terminal Value are Year 2 = 200 *(1+4%)/(7% - 4%) =  6,933

PV of Year 1 @ 7% =  112

PV of Year 2 + Terminal value @ 7% =  6,231

Value of the company = 112 + 6,231 =  6,343

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