Question 21 As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D 0 = $0.80; P 0 = $22.50; and g L = 8.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings? a. 11.25% b. 10.69% c. 11.84% d. 12.43% e. 13.05%
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Question 21
| a. |
11.25%
|
|
| b. |
10.69%
|
|
| c. |
11.84%
|
|
| d. |
12.43%
|
|
| e. |
13.05%
|
| Cash |
$ 14,000 |
Accounts payable |
$ 42,000 |
| Receivables |
70,000 |
Other current liabilities |
28,000 |
| Inventories |
210,000 |
Total CL |
$ 70,000 |
| Total CA |
$294,000 |
Long-term debt |
70,000 |
| Net fixed assets |
126,000 |
Common equity |
280,000 |
| Total assets |
$420,000 |
Total liab. and equity |
$420,000 |
| Sales |
$280,000 |
||
| Net income |
$ 21,000 |
The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the
| a. |
4.28%
|
|
| b. |
5.21%
|
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| c. |
4.73%
|
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| d. |
4.50%
|
|
| e. |
4.96%
|
Question 31
| Decker Enterprises | ||||||
| Below are the simplified current and projected financial statements for Decker Enterprises. All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities. | ||||||
| Income statement |
Current |
Projected | ||||
| Sales |
na |
1,500 |
||||
| Costs |
na |
1,080 |
||||
| Profit before tax |
na |
420 |
||||
| Taxes (25%) |
na |
105 |
||||
| Net income |
na |
315 |
||||
| Dividends |
na |
95 |
||||
| Balance sheets | Current | Projected | Current | Projected | ||
| Current assets |
100 |
115 |
Current liabilities |
70 |
81 |
|
| Net fixed assets |
1,200 |
1,440 |
Long-term debt |
300 |
360 |
|
| Common stock |
500 |
500 |
||||
|
430 |
650 |
| a. |
buying back common stock
|
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| b. |
borrowing on its line of credit
|
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| c. |
paying a special dividend
|
|
| d. |
borrowing from retained earnings
|
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| e. |
paying down its long-term debt
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