The stock of Gao Computing sells for $50, and last years dividend was $2.10. A flotation cost of 10% would be required to issue new common stock. Gaos preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 7% a year. The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 35%. The market risk premium is 6%, the risk-free rate is 6.5%, and Gaos beta is 0.83. In its cost-of-capital calculations, Gao uses a target capital structure with 45% debt, 5% preferred stock, and 50% common equity.

a) Calculate the cost of each capital componentin other words, 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 CAPM method and the dividend growth approach to find the cost of equity.

b) Calculate the cost of new stock using the dividend growth approach.

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 dividend growth approach and then add that difference to the CAPM value for rs.)

d) Assuming that Gao will not issue new equity and will continue to use the same target capital structure, what is the companys WACC?

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 and an expected return of 9.0%.

3. Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%.

4. Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%.

f) Analyze the companys situation, and explain why each project should be accepted or rejected.

Student 10/14/2016 Chapter: 11 Problem: 18 INPUTS USED IN THE MODEL $50.00 Po Net Pet $30.00 De Do $3.30 $2.10 7% B-T ra Skye's beta Market risk premium, RPM 10% 0.83 6.0% Risk free rate, fRF 6.5% Target capital structure from debt Target capital structure from preferred stock Target capital structure from common stock Tax rate 45% 5% 50% 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 the CAPM method and the dividend growth approach to find the cost of equity. Cost of debt: A-T ra B-T r. (1 - T) Cost of preferred stock (including flotation costs): Net Pe De Cost of common equity, dividend growth approach (ignoring flotation costs): D, P. Cost of common equity, CAPM: b x RPM TRE + IMPORTANT NOTE: HERE THE CAPM AND THE DIVIDEND GROWTH METHODS PRODUCE APPROXIMATELY THE SAME COST OF EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE SAME RESULT. ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS. b. Calculate the cost of new stock using the dividend growth approach. Do x (1 + g) Pa- (1 - F) c. What Is the cost of new common stock based on the CAPM? (Hint: Find the difference between r. and r, as determined by the dividend growth approach and add that differential to the CAPM value for r..) Differential Again, we would not normally find that the CAPM and dividend growth methods yield identical results. d. Assuming that Gao will not Issue new equity and will continue to use the same capital structure, what Is the company's WACC? 45.0% 5.0% 50.0% 100.0% Wa x A-T ra + WACC W, x , 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 reimvested 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 company's situation and explain why each project should be accepted or rejected. Expected return on ra(1 - T) project Beta WACC Project A Project B Project C 0.5 1.0 2.0 The expected returns on Projects A and B both exceed their risk-adjusted WACCS, so they should be accepted. However, Project C's WACC exceeds its expected rate of return, so it should be rejected