Question
Roberto Inc. is a manufacturing company. The company has always followed their ideal capital structure which the management insists is 40% debt and 60% equity
Roberto Inc. is a manufacturing company. The company has always followed their ideal capital structure which the management insists is 40% debt and 60% equity capital. The company can issue bonds for 9% coupon rate with 22 years to maturity. The interest is paid semi-annually. The bonds can be issued with a price of $835.42 today. Roberto's marginal tax rate is 40%. For cost of equity, the company uses the CAPM (Capital Asset Pricing Model) based on SML (Security Market Line). The risk-free rate in the market is 8% and the market rate of return is 14%. The company has a beta of 1.1. Roberto is experiencing a highly abnormal growth rate of 30%. This growth rate is expected to continue for four years. After year four, the growth rate is expected to return to a normal 8% and remain constant afterwards for the foreseeable future. Roberto just paid a dividend of $1.15. Furthermore, Roberto is evaluating several projects to invest in. The top project that is being considered will cost $1,000,000 and promises to pay $500,000 in year one, $400,000 in year two, $300,000 in year three and $100,000 in year four. This project will cease to exist with no salvage value at end of year four. So, the cash flow would look like the following:
Year CF ($ in 000's)
1 -1,000 (Initial Outlay)
2 500
3 400
4 300
5 100
Based on the information provided above, answer the following question:
1. What is the company's cost of equity capital using the CAPM?
a. 9.6%
b. 8%
c. 14.6%
d. 12.09%
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