Following table shows the actual amounts for year 2016 and projections for next 5 years of the firm KNJ (amounts are in millions).

	Actual		Projected
	2016		Year + 1	Year + 2	Year + 3	Year + 4	Year + 5
Comprehensive Income	$3,100		$2,944	$3,069	$3,199	$3,335	$3,475
Common shareholders’ equity Paid-in Capital $659 $694 $714 $732 $749 $764 Retained Earnings $12,163 $12,604 $12,837 $12,989 $13,036 $12,977 Accumulated Other ($100) ($100) ($100) ($100) ($100) ($100) Comprehensive Income
Total Common Equity	$12,722		$13,198	$13,451	$13,621	$13,685	$13,641

Assume the following at beginning of Year + 1 for KNJ:

1. Market equity beta for KNJ is 1.00

2. Risk free interest rate is 3.0% and market risk premium is 6.00%.

3. KNJ has 500 million outstanding shares and is trading at $71 per share.

4. KNJ’s outstanding interest bearing debt is $8,200 million. Assume that the market value of the

debt is also $8,200 million. The interest rate is 4.0%.

5. There are no preferred stocks.

6. KNJ has $940 million in equity capital from non-controlling interests. The required rate of return

for the non-controlling interests is 15%.

7. The average tax rate is 30%

Questions: (Already answered A thru D - PLEASE answer E through I. Thank you!

a. Use CAPM to compute the required rate of return on common equity capital. ANSWER -

cost of equity = risk free rate + Beta * market risk premium

= 3% + 1 * 6% = 9%

b. Compute the weighted-average cost of capital ANSWER -

WACC = (debt/capital)* after-tax cost of debt + (equity/capital)*cost of equity

Note that as per clean ssurplus accounting we include Non controlling interest in equity to ensure more accurate valuation.

WACC = 0.375 * 0.04 *(1-0.3) + 0.625 * 0.09 = 6.67%

c. Use the clean surplus accounting approach to derive the projected dividends for common

shareholders for Year + 1 through Year + 5 based on comprehensive income and shareholders’

equity. Throughout this problem, you can ignore the dividends to the noncontrolling interests. ANSWER

c. Dividends

	year +1	year +2	year +3	year +4	year +5	year +6
Comprehensive income	2944	3069	3199	3335	3475	3579
Other comp. income	0	0	0	0	0	0
Income	2944	3069	3199	3335	3475	3579
BV(t-1)	12722	13198	13451	13621	13685	13641
BV(Tt)	13198	13451	13621	13685	13641	14030
Dividend	2468	2816	3029	3271	3519	3190

Dividend = Income + Book value last year - Book Value this year

where, income includes both comprehensive and other comprehensive income. In this case, since accumulated other comprehensive income does not change, I have assumed other comprehensive income as zero.

d. Use the clean surplus accounting approach to project the continuing dividends for common

shareholders in Year + 6. Assume that the steady-state long-run growth rate will be 3% in Year+6

and beyond. ANSWER

d. Projected Dividend

Refer table above. For year +6, we have increased the comprehensive income and retained earnings by 3%. Paid in capital do not necessarily change every year, hence i have kept it constant at year+5 level. For accumulated other comprehensive income, i have followed the historical trend and kept it at same level.

	2016	year +1	year +2	year +3	year +4	year +5	year +6
Comprehensive income	3100	2944	3069	3199	3335	3475	3579
Paid in capital	659	694	714	732	749	764	764
Retained earnings	12163	12604	12837	12989	13036	12977	13366
Acc. Other comp income	-100	-100	-100	-100	-100	-100	-100
Total comon equity	12722	13198	13451	13621	13685	13641	14030

e. Using the required rate of return on common equity as discount rate, calculate the present

value of the dividends for years Year + 1 through Year + 5.

f. Using the required rate of return on common equity as discount rate and long-run growth rate

of 3%, calculate the present value of continuing value of KNJ as of the start of Year + 1.

g. Compute the value of share of common stock (Compute the sum of present value of dividends for Year + 1 through Year + 5 and present value of continuing value, apply midyear discounting adjustment, and calculate per share value).

h. Using the same assumptions made earlier, re-compute the KNJ share value for the two following scenarios:

Scenario 1: Long-run growth rate as 2% (not 3% as before) and assume that the required rate of return on equity is 1 percentage point higher than the one calculated in question (a).

Scenario 2: Long run growth rate as 4% (not 3% as before) and assume that the required rate of return on equity is 1 percentage point lower than the one calculated in question (a).

i. Do you recommend buy or sell of KNJ share based on the current price and the value range calculated above?