North Star is trying to determine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the firm has no plans to use preferred stock in its capital structure. In addition, the firm’s size will remain the same, so funds obtained from debt issued will be used to repurchase stock. The percentage of shares repurchased will be equal to the percentage of debt added to the firm’s capital structure. (In other words, if the firm’s debt-to-capital ratio increases from 0 to 25%, then 25% of the shares outstanding will be repurchased.) North Star is a small firm with average sales of $25 million or less during the past 3 years, so it is exempt from the interest deduction limitation. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm’s debt cost at different debt levels: Debt-to-Capital Ratio (Wd) Equity-to-Capital Ratio (Wc) Debt-to-Equity Ratio (D/E) Bond Rating Before-Tax Cost of Debt (rd) 0.00 1.00 0.0000 AA 5.0% 0.25 0.75 0.3333 A 6.0 0.50 0.50 1.0000 BBB 8.3 0.75 0.25 3.0000 BB 11.0 The firm has total capital of $5 million and 200,000 shares of common stock outstanding. Its EBIT is $500,000 and will not change if debt, at any of the levels shown in the preceding table, is added to the firm’s capital structure. North Star uses the CAPM to estimate its cost of common equity, . It estimates that the risk-free rate is 3.5%, the market risk premium is 4.5%, and its tax rate is 25%. North Star’s current beta, which is because it has no debt, is 1.25. Calculate the firm’s net income for each of the capital structures shown in the preceding table. (Wd) (Wc) (rd) EBIT NI 0.00 1.00 5.0% 500,000 0.25 0.75 6.0 500,000 0.50 0.50 8.3 500,000 0.75 0.25 11.0 500,000
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
North Star is trying to determine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the firm has no plans to use
Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm’s debt cost at different debt levels:
|
Debt-to-Capital Ratio (Wd) |
Equity-to-Capital Ratio (Wc) |
Debt-to-Equity Ratio (D/E) |
Bond Rating |
Before-Tax Cost of Debt (rd) |
| 0.00 | 1.00 | 0.0000 | AA | 5.0% |
| 0.25 | 0.75 | 0.3333 | A | 6.0 |
| 0.50 | 0.50 | 1.0000 | BBB | 8.3 |
| 0.75 | 0.25 | 3.0000 | BB | 11.0 |
The firm has total capital of $5 million and 200,000 shares of common stock outstanding. Its EBIT is $500,000 and will not change if debt, at any of the levels shown in the preceding table, is added to the firm’s capital structure. North Star uses the
Calculate the firm’s net income for each of the capital structures shown in the preceding table.
(Wd) (Wc) (rd) EBIT NI
0.00 1.00 5.0% 500,000
0.25 0.75 6.0 500,000
0.50 0.50 8.3 500,000
0.75 0.25 11.0 500,000
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