Question

Summerdahi Resort’s common stock is currently trading at $37.15 a share. The stock is expected to pay a dividend of $2.50 a share at the end of the year (D1 = $3.00), and the dividend is expected to grow at a constant rate of 8.25% a year. What is its cost of common equity?

5. Booher Book Stores has a beta of 1.30. The yield on a 3-month T-bill is 4.5%. The market risk premium is 7.5% and the return on an average stock in the market last year was 12%. What is the estimated cost of common equity using CAPM?

6. Shi Import Export’s balance sheet shows $250 million in debt, $50 million in preferred stock, and $300 million in total common equity. Shi’s tax rate is 23%, rd = 8.5%, rp = 9.87%, and rs = 15.5%. If Shi has a target capital structure of 40% debt, 5% preferred stock and 55% common stock, what it its WACC?

please complete in excel

Answer 1

Summerdahi Resort’s common stock is currently trading at $37.15 a share. The stock is expected to pay a dividend of $2.50 a share at the end of the year (D1 = $3.00), and the dividend is expected to grow at a constant rate of 8.25% a year. What is its cost of common equity?

We have following formula to calculate cost of common equity with constant dividend growth

P0 = D1 / (re –g)

Where

Current Price of stock P0 = $37.15 per share

Expected Dividend next year D1 = $3.00

Expected Constant Dividend growth rate g = 8.25% per year

Cost of common equity or required rate of return re =?

Therefore

Stock Price $37.15 = $3.00/ (re% - 8.25%)

Or re = ($3.00/$37.15) + 8.25% = 0.1633 16.33%

Therefore required return on the stock or cost of common equity is 16.33%

5. Booher Book Stores has a beta of 1.30. The yield on a 3-month T-bill is 4.5%. The market risk premium is 7.5% and the return on an average stock in the market last year was 12%. What is the estimated cost of common equity using CAPM?

The estimated cost of common equity using CAPM

Required rate of return or cost of equity = risk free rate (rRF) + beta of stock *[Expected market return (rM) – risk free rate (rRF)]

Where,

Required rate of return of stock or cost of equity, re =?

Yield of current treasury bills or Risk free rate (rRF) = 4.5%

Beta of the stock = 1.30

The expected return on the market rM = 12%

Now putting all the values into formula, we get

Required rate of return or cost of equity = 4.5% + 1.30 * (12% - 4.5%)

= 14.25%

Therefore cost of equity is 14.25%

6. Shi Import Export’s balance sheet shows $250 million in debt, $50 million in preferred stock, and $300 million in total common equity. Shi’s tax rate is 23%, rd = 8.5%, rp = 9.87%, and rs = 15.5%. If Shi has a target capital structure of 40% debt, 5% preferred stock and 55% common stock, what it its WACC?

The weighted average cost of capital (WACC) is the cost of raising capital, with the weights representing the proportion of each source of financing that is used.

WACC = wd * rd (1 - t) + wcs*rs + wps * rp          

Where,

WACC =?

rd is the cost of debt = 8.5%

Tax rate t = 23%

rs is the cost of equity =15.5%

rp is the cost of preferred stock = 9.87%

wd is the weight of debt = 40%

wps is the weight of preferred stock = 5%

wcs is the weight of common stock = 55%

Therefore,         

WACC = 40% * 8.5% (1-23%) + 55% *15.5% + 5% * 9.87%

= 11.6365% or 11.64%

Weightage average Cost of capital (WACC) is 11.64%