Question 18:

Assume that you are the CFO of Microsoft and you were asked to estimate the cost of capital. Microsoft has 100 bonds ($1,000 par value) that now has 20 years to maturity and a 7.00% annual coupon. The bond currently sells for $925 and the companys tax rate is 30%. Moreover, Microsoft has 5,000 common stock ($5 par value) and it expects to earn $8 per share (EPS=$8) during the next year with a 75% constant retention ratio, its expected constant dividend growth rate is 5% (g=%5), and its common stock currently sells for $20 per share (P0=$20). Microsoft has a beta of 1.2. The market return is 14% (Rm=14%) and the yield on a Treasury bond is 4% (Rf=4%).

The company recently decided that its target capital structure should have 35% debt, with the balance being common equity.

Required: a. Calculate the best estimate of the cost of equity using CAPM?

b. Calculate the best estimate of the cost of equity using DDM?

c. What is the best estimate of the firm's WACC using market value weights and CAPM for cost of equity?

d. What is the best estimate of the firm's WACC using book value weights and DDM for cost of equity?