11/25/2006

Chapter 10. Ch 10 P18 Build a Model

INPUTS USED IN THE MODEL P0 Net Ppf Dpf D0 g B-T rd Skye's beta Market risk premium, MRP Risk free rate, rRF Target capital structure from debt Target capital structure from preferred stock Target capital structure from common stock Tax rate Flotation cost for common $50.00 $30.00 $3.30 $2.10 7% 10% 0.83 6.0% 6.5% 45% 5% 50% 35% 10%

a. Calculate the cost of each capital component, i.e., the after-tax cost of debt, the cost of preferred stock (including flotation costs), the cost of equity (ignoring flotation costs) with the DCF method and the CAPM method. Cost of debt B-T rd x (1-T) = A-T rd

Cost of preferred stock (including flotation costs) Dpf / Net Ppf = rpf

Cost of common equity, DCF (ignoring flotation costs) D1 / P0 + g = rs

Cost of common equity, CAPM rs = rRF

+

b * MRP = =

IMPORTANT NOTE: HERE THE CAPM AND THE DCF METHODS PRODUCE APPROXIMATELY THE SAME COST OF EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT ESTIMATED FORCED THE SAME RESULT. ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS.

b. Calculate the cost of new stock using the DCF model. D0 * (1+g) / P0*(1-F) + g = re

c. What is the cost of new common stock, based on the CAPM? (Hint: Find the difference between r e and rs as determined by the DCF method, and add that differential to the CAPM value for r s. re
=

rs

+ +

Differential =

Again, we would not normally find the CAPM and DCF methods to yield identical results. d. Using the target capital structure for Gao Computer and assuming that it will not issue new equity, will continue to use the same capital structure, what is the WACC? wd wpf ws 45.0% 5.0% 50.0% 100.0% wd * A-T rd + wpf * rpf + ws * rs = WACC

e. Suppose Gao is evaluating three projects with the following characteristics: (1) Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. No new equity will be issued. (2) Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0%. (3) Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%. (4) Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%. f. Analyze the companys situation and explain why each project should be accepted or rejected. Expected return on project

Project A Project B Project C

Beta 0.5 1.0 2.0

rs

rps

rd(1-T)

WACC

The expected returns on Projects A and B both exceed their risk-adjusted WACCs, so they should be accepted. However, Project C's WACC exceeds its expected rate of return, so it should be rejected.