23. Calculating the Cost of Equity. Holiday Industries stock has a beta of 1,20. The company ¡ust paid a dividend of $.80, and the dividends are expected to grow at 6 percent. The expected return of the market is 12.5 percent, and Treasury bills are yielding 5 percent. The most recent stock price is $72.
a. Calculate the cost of equity using the dividend growth model method.
I). Calculate the cost of equity using the SML method.
c. Why do you think your estimates in (a) and (b) are so different?
24. Flotation Costs and NPV. Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of 0.8. It's considering building a new $80 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $10.9 million in perpetuity. The company raises all equity from outside financing. There are three financing options:
a. -4 riew issue of common stock: The required return on the company's new equity is 17 percent.
b. A new issue of 20-year bonds • If the company issues these new bonds at an annual coupon rate of 9 percent, they will sell at par.
c. Increased use of accounts payable financing: Because this financing is part of the company's ongoing daily business, the company assigns it a cost that is the same as the overall firm WACC. Management has a target ratio of accounts payable to long-term debt of .20. (Assume there is no difference between the pretax and aftertax accounts payable cost.)
What is the NPV of the new plant? Assume that the company has a 35 percent tax rate.
25. Project Evaluation. This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project, The company bought some land three years ago for $6 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the land were sold today, the net. proceeds would be S6.4 million after taxes. In five years, the land will be worth $7 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $9.8 million to build. The following market data on DEI's securities are current:
Debt: 25,000 6.5 percent coupon bonds outstanding, 20 years to maturity, selling for 96 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock: 400,000 shares outstanding, selling for $89 per share: the beta is 1.20.
Preferred stock: 35,000 shares of 6.5 percent preferred stock outstanding, selling for $99 per share.
Market: 8 percent expected market risk premium: 5.20 percent risk-free rate.
DEI's tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operational.
a. Calculate the project's Time 0 cash flow, taking into account all side effects.
b. The new RDS project is somewhat riskier than a typical project for DEL primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI's project.
c. The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $1.25 million. What is the aftertax salvage value of this manufacturing plant''
d. The company will incur $2,100,000 in annual fixed costs. The plan is to manufacture 11,000 RDSs per year and sell them at $10,000 per machine: the variable production costs are $9,300 per RDS. What is the annual operating cash flow, OCR from this project?
e. Finally, DEFs president wants you to throw all your calculations, all your assumptions, and everything else into a report for the chief financial officer; all he wants to know is what the RDS project's interna! rate of return, IRR. and net present value, NPV, are. What will you report?
12.1 Cost of Equity. Go to finance.yahoo.com and look up the information for Washington Mutual (WM), a financial services company in the S&P500. You want to estimate the cost of equity for the company. First, find the current Treasury bill rate. Next, find the beta for Washington Mutual. Using the historical market risk premium, what is the estimated cost of equity for Washington Mutual using the CAPM? Now find the analyst's growth rate estimates for the next five years for the company. Using this growth rate in the dividend discount model, what is the estimated cost of equity? Now find the dividends paid by the company over the past five years and calculate the arithmetic and geometric growth rates in dividends. Using these growth rates, what is the estimated cost of equity? Looking at these four estimates, what cost of equity would you use for the company?
12.2 Cost of Debt. Go to www.nasdbondinfo.com and look up the outstanding bonds for Nike. Record the most recent price and YTM of each bond issue. Now go to www.sec.gov and find the most recent 10Q or I OK report filed by the company and find the book value of each bond issue. Assuming Nike's tax rate is 38 percent, what is the cost of debt using book value weights? What is the cost of debt using market value weights? Which of these numbers is more relevant?
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