Problem Assignments and Solutions - Capital Structure We are given the answers. I am unsure of what formulas to use and why. 1 The corporate treasurer of Ajax Company expects the company to grow at 4% in the future, and debt securities at 6% interest (tax rate = 30%) to be a cheaper option to finance the growth. The current market price per share of its common stock is $39, and the expected dividend in one year is $1.50 per share. Calculate the cost of the company's retained earnings and check if the treasurer's assumption is correct. Answer: Cost of debt after tax is 4.20% Cost of retained earnings is 7.85% 2 The risk-free rate on 10-year U.S. Treasury bills is 3% and the expected rate of return on the overall stock market is 11%. The company has a beta of 1.6. What is the cost of equity? Answer: The cost of equity is 15.80% 3 A company has a capital structure as follows: Total Assets $600,000 Debt $300,000 Preferred Stock $100,000 Common Equity $200,000 What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital? Assume the applicable tax rate is 40%, interest on debt is 11%, flotation cost per share of preferred stock is $0.75, and flotation cost per share of common stock is $4. The preferred and common stocks are selling in the market for $26 and $143 a share respectively, and they are expected to pay a dividend of $2 and $7, repectively, in one year. The company's dividends are expected to grow at 13% per year. The firm would like to maintain the existing capital structure to finance the new project. Answer: The minimum expected return from a new capital investment project is the WACC plus any additional risk premium. Since no additional risk is mentioned, we will use the WACC. Cost of debt after tax is 6.60% Cost of preferred stock is 7.92% Cost of common stock is 18.04% WACC is 10.63% 4 Required rate of return is 10%. Net Cash Flow Year Project A Project B 0 -$2,000 -$2,500 1 $900 $1,500 2 $1,100 $1,300 3 $1,300 $800 a) Calculate the payback period for each project. Project A Project B Answer: 2.00 1.77 Payback Period in years. b) Calculate the net present value for each project. Project A Project B Answer: $703.98 $539.07 c) Which project do you think will be approved, if only one project can be approved? Why? Project A Project B Answer: Yes No d) What if the required rate of return was 20%? Answer: Project A Project B $266.20 $115.74 Net Present Value Yes No 5 A corporate bond has a face value of $1,000 and an annual coupon interest rate of 7%. Interest is paid annually. 10 years of the life of the bond remain. The current market price of the bond is $872. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today? Answer: 9% 6 Ajax Manufacturing is expected to pay a dividend of $8 per share next year. The dividend growth rate is expected to continue to be 3%. Required rate of return is 14%. a) What should be the current market price per share? Answer: $72.73 b) What is the annual rate of return if you purchase the stock at $65? Answer: 15.31% 7 A common stock sells for $82 per share, has a growth rate of 7% and a dividend that was just paid of $3.82. What is the annual percent yield per share? D0 = $3.82 and therefore D1 = $3.82 x 1.07 = $4.09 Answer: 11.98% 8 A corporate bond has a face value of $1,000 and an annual coupon interest rate of 6%. Interest is paid annually. 12 years of the life of the bond remain. The current market price of the bond is $1,027, and it will mature at $1,100. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today? Answer: 6%

Problem Assignments and Solutions - Capital Structure 1 The corporate treasurer of Ajax Company expects the company to grow at 4% in the future, and debt securities at 6% interest (tax rate = 30%) to be a cheaper option to finance the growth. The current market price per share of its common stock is $39, and the expected dividend in one year is $1.50 per share. Calculate the cost of the company's retained earnings and check if the treasurer's assumption is correct. Answer: Cost of debt after tax is 4.20% Cost of retained earnings is 7.85% 2 The risk-free rate on 10-year U.S. Treasury bills is 3% and the expected rate of return on the overall stock market is 11%. The company has a beta of 1.6. What is the cost of equity? Answer: The cost of equity is 15.80% 3 A company has a capital structure as follows: Total Assets $600,000 Debt $300,000 Preferred Stock $100,000 Common Equity $200,000 What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital? Assume the applicable tax rate is 40%, interest on debt is 11%, flotation cost per share of preferred stock is $0.75, and flotation cost per share of common stock is $4. The preferred and common stocks are selling in the market for $26 and $143 a share respectively, and they are expected to pay a dividend of $2 and $7, repectively, in one year. The company's dividends are expected to grow at 13% per year. The firm would like to maintain the existing capital structure to finance the new project. Answer: The minimum expected return from a new capital investment project is the WACC plus any additional risk premium. Since no additional risk is mentioned, we will use the WACC. Cost of debt after tax is 6.60% Cost of preferred stock is 7.92% Cost of common stock is 18.04% WACC is 10.63% 4 Required rate of return is 10%. Net Cash Flow Year Project A Project B 0 -$2,000 -$2,500 1 $900 $1,500 2 $1,100 $1,300 3 $1,300 $800 a) Calculate the payback period for each project. Project A Project B Answer: 2.00 1.77 Payback Period in years. b) Calculate the net present value for each project. Project A Project B Answer: $703.98 $539.07 c) Which project do you think will be approved, if only one project can be approved? Why? Project A Project B Answer: Yes No d) What if the required rate of return was 20%? Answer: Project A Project B $266.20 $115.74 Net Present Value Yes No 5 6 A corporate bond has a face value of $1,000 and an annual coupon interest rate of 7%. Interest is paid annually. 10 years of the life of the bond remain. The current market price of the bond is $872. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today? Answer: 9% Ajax Manufacturing is expected to pay a dividend of $8 per share next year. The dividend growth rate is expected to continue to be 3%. Required rate of return is 14%. a) What should be the current market price per share? Answer: $72.73 b) What is the annual rate of return if you purchase the stock at $65? Answer: 15.31% 7 A common stock sells for $82 per share, has a growth rate of 7% and a dividend that was just paid of $3.82. What is the annual percent yield per share? D0 = $3.82 and therefore D1 = $3.82 x 1.07 = $4.09 Answer: 11.98% 8 A corporate bond has a face value of $1,000 and an annual coupon interest rate of 6%. Interest is paid annually. 12 years of the life of the bond remain. The current market price of the bond is $1,027, and it will mature at $1,100. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today? Answer: 6%