Problem 3 (10 marks)

The Smith Company has 10,000 bonds outstanding. The bonds are selling at 102% of face value, have a 8% coupon rate, pay interest annually, mature in 10 years, and have a face value of $1,000. There are 500,000 shares of 9% preferred stock outstanding with a current market price of $91 a share and a par value of $100. In addition, there are 1.25 million shares of common stock outstanding with a market price of $64 a share and a beta of .95. The most recent dividend paid by the company on the common stock was of $1.10 and it expects to increase those dividends by 3% annually forever. The firm's marginal tax rate is 35%. The overall stock market is yielding 12% and the Treasury bill rate is 3.5%.

1. What is the cost of equity based on the dividend growth model? (2 marks)

2. What is the cost of equity based on the security market line? (2 marks)

3. What market weights should be given to the various capital components in the weighted average cost of capital computation? (3 marks)

4. What is the weighted average cost of capital using the cost equity calculated based on CAPM? (3 marks)