d. Estimate the cost of equity raised by issuing new shares using the dividend growth method. e. Calculate the cost of retained earnings using three approaches; CAPM, dividend growth method and risk premium. Reconcile the three approaches into a single estimate for the cost of retained earnings. f. Using the target capital structure, calculate the WACC, including retained earnings. Where is the first bro
d. Estimate the cost of equity raised by issuing new shares using the dividend growth method. e. Calculate the cost of retained earnings using three approaches; CAPM, dividend growth method and risk premium. Reconcile the three approaches into a single estimate for the cost of retained earnings. f. Using the target capital structure, calculate the WACC, including retained earnings. Where is the first bro
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
Related questions
Question
Solution for d, e, and f
Transcribed Image Text:ABCDE
Latimore Constructions Corp has the following capital situation:
Debt: The firm issued 10,000 25 year bonds 10 years ago at their par value of $1000. The
bonds carry a coupon rate of 8% and are now selling to yield 10%.
Preferred Stock: The company sold 30,000 shares of preferred stock six years ago at a par value
of $50. The shares pay a dividend of 8%. Similar securities are no yielding 9%.
Equity: Latimore's initial financing was a sale a 2 million shares of common stock at $12 per
share. Retained Earnings are now $5 million. The current stock price is $13.25.
The Target capital structure that Latimore aims to maintain is 30% debt, 5% preferred stock and
65% common stock.
Other information:
> Latimore's marginal tax rate (state and federal) is 40%.
> Flotation costs average 12% for common and preferred stock.
> Short term Treasury bills currently yield 7.5%.
The expected return on stocks is 12.5%.
Latimore's beta is 1.20.
Latimore expects steady growth at 6% to continue.
> The last annual dividend was $1.00 per share.
> Latimore expects to earn $5 million after taxes next year.
> The firm can borrow an additional $2 million at rates similar to the market rate on its
existing debt. Beyond that, lenders are expected to demand a higher return in the area
of 14%.
> The following capital budgeting projects are under consideration:
Capital Required
$3 million
$2 million
$2 million
$2 million
$2 million
Cumulative Capital
$3 million
$5 million
$7 million
$9 million
$11 million
Project
IRR
15%
14%
13%
12%
11%
Complete the following assignment:
a. Calculate the firm's existing capital structure based on book value and again based on
market value. How does it compare to the target capital structure?
Book value:
Debt = 10,000 x 1,000 = 10,000,000
Focus
B IU 2 A = =
Transcribed Image Text:Market Value:
Debt = 10,000,000 x 8% / 10 % = 8,000,000
%3D
The percentage of debt under the market and book value capital structure is less than 30 %
which shows the company is using less than the target debt proportion. Preferred stock has
been mentioned at less than 4% of total capital but under the target, it has been around 5%
which means the company is using less preferred capital than the target structure. According to
the target capital structure, the equity comprises 65% in the total capital but according to the
market and book value the equity is 755 so it shows that the company has used more equity.
b. What is the current cost of debt for the company? 4.8%
c. What is the cost of preferred stock ? 8%
= 8% x 50/ 50 = 4/50
d. Estimate the cost of equity rased by issuing new shares using the dividend growth method.
e. Calculate the cost of retained earnings using three approaches; CAPM, dividend growth
method and risk premium. Reconcile the three approaches into a single estimate for the cost of
retained earnings.
f. Using the target capital structure, calculate the WACC, including retained earnings.
g. Where is the first breakpoint in the Marginal Cost of Capital (MCC). That is, the point where
retained earnings run out.
h. Calculate the WACC after the first breakpoint.
i, Calculate the WACC after the second breakpoint.
k. Plot the MCC for Latimore.
1. Which projects should be accepted and which projects should be rejected, based on this
analysis only?
Focus
A
E E
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