INPUTS USED IN THE MODEL

P₀ $45.00

Net P_pf $28.00

D_pf $3.25

D₀ $2.20

g 6%

B-T _rd 9%

Skye's beta 1.05

Market risk premium, RP_M 5.5%

Risk free rate, r_RF 5.5%

Target capital structure from debt 40%

Target capital structure from preferred stock 5%

Target capital structure from common stock 55%

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 (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the DCF method and the CAPM method to find the cost of equity.

Cost of debt: (Forumal to use to calcuate Cost of Debt : B-T r_d (1 T) = A-T _rd )

Cost of preferred stock (including flotation costs): (Forumal to use to calculate Cost of preferred stock : D_pf / Net P_pf = r_pf)

Cost of common equity, DCF (ignoring flotation costs): (Forumla to calculate Cost of common equity DCF: D₁ / P₀ + g = r_s)

Cost of common equity, CAPM: (Formula to calculate Cost of common equity, CAPM : r_RF + b RP_M = r_s)

IMPORTANT NOTE: THE CAPM AND THE DCF METHODS MAY PRODUCE A VERY SIMILAR COST OF EQUITY.

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

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 DCF method and add that differential to the CAPM value for rs.)

d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company's WACC?

w_d 40.0%

w_pf 5.0%

w_s 55.0%

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. 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 companys situation and explain why each project should be accepted or rejected.

Expected Accept? return on (Yes or rps TWACC pojct No) Beta 0.5 Ts Project A Project B Project C 2.0