7% INPUTS USED IN THE MODEL Po $50.00 Net Ppt $30.00 Dpf $3.30 Do $2.10 g B-T rd 10% Skye's beta 0.83 Market risk premium, RPM 6.0% Risk free rate, IRF 6.5% Target capital structure from debt 45% Target capital structure from preferred stoc 5% Target capital structure from common stoc 50% Tax rate 35% Flotation cost for common 10% a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock Cost of debt: B-T rd (1 -T) = A-T rd Grading 2 points Cost of preferred stock (including flotation costs): Dpf 1 Net Ppf = 2 points Cost of common equity, dividend growth approach (ignoring flotation costs): D1 Po g 2 points Cost of common equity, CAPM: TRF + b x RPM Is 2 points IMPORTANT NOTE: HERE THE CAPM AND THE DIVIDEND GROWTH METHODS PRODUCE APPROXIMATELY THE SAME COST OF EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE SAME RESULT. ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS. b. Calculate the cost of new stock using the dividend growth approach. 02 = Do X (1 + g) Pox (1 - F) + g II re 2 points Wpf + c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the dividend growth approach and add that differential to the CAPM value for rs.) Is Differential 2 points Again, we would not normally find that the CAPM and dividend growth methods yield identical results. d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company's WACC? Wd 45.0% 5.0% Ws 50.0% 100.0% Wd X A-T rd + Wpf X Ppt Ws X rs WACC 2 points 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, pref stock, and common equity. The cost of the common equity for each project should be based on the beta the project. All equity will come from reinvested earnings. (2) Equity invested in Project A would have a beta of 0.5. The project has an expected return of 9.0%. (3) Equity invested in Project B would have a beta of 1.0. The project has an expected return of 10.0%. (4) Equity invested in Project C would have a beta of 2.0. The project has an expected return of 11.0%. Analyze the company's situation and explain why each project should be accepted or rejected. Expected return on Beta re(1 - T) WACC project Project A 0.5 Project B 1.0 Project C 2.0 Is ros