Question

QUESTION 7

1. Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5 percent and the tax rate is 34 percent. What is the cost of equity if the aftertax cost of debt is 5.5 percent?

QUESTION 8

1. In a single sentence, explain how you can determine which cash flows should be included in the analysis of a project.

10 )

Thayer Farms stock has a beta of 1.12. The risk-free rate of return is 4.34 percent and the market risk premium is 7.92 percent. What is the expected rate of return on this stock?

Answer 1

ANSWER TO 7

GIVEN : Debt-equity ratio = 0.72

WACC = 11.5%

Tax = 34%

After tax cost of debt (Kd)= 5.5 %

TO FIND : Cost of Equity (Ke)= ?

Since, debt-equity ratio is 0.72, therefore weight of debt is 0.72 and weight of equity is 1.

Now, we know,

WACC = Ke x We + Kd x Wd

0.115 = Ke X 1/(1+0.72) + 0.055 X 0.72/(1+0.72)

0.115 = Ke X 1/1.72 + 0.055 X 0.72/1.72

0.115 X 1.72 = Ke + 0.0396

Ke = 0.1582

Therefore, Cost of equity is 15.82%.

ANSWER TO 8

(a) In the analysis of a project all cash inflows and outflows that are generated by the project alongwith more indirect implications such as sunk costs, opportunity costs and depreciation costs related to the project are taken into account.

(b) GIVEN : Beta of stock = 1.12

Risk-free rate of return (Rf) = 4.34%

Market risk premium (Rm-Rf) = 7.92%

TO FIND : Expected rate of return of stock = ?

Now, we know, as per Capital Asset Pricing Model,

Expected rate of return = Risk-free rate of return + (Market risk premium X Beta)

  Expected rate of return = 4.34 + (7.92 X 1.12)

  Expected rate of return = 4.34 + 8.8704

  Expected rate of return = 13,2104

Therefore, expected rate of return on stock is 13.21%