Zapata Enterprises is financed by two sources of funds: bonds and common stock.
The cost of
capital for funds provided by bonds is k₁, and ke is the cost of capital for equity funds. The capital
structure consists of B dollars' worth of bonds and S dollars' worth of stock, where the amounts
represent market values. Compute the overall weighted average of cost of capital, k ..The
formula for the weighted average cost of capital (WACC), k, is:
k = (B / (B + S)) * k1 + (S / (B + S)) * ke
where:- B = Market value of bonds- S = Market value of equity (stock)- k1 = Cost of debt - ke
= Cost of equity
2. Assume that B (in Problem 1) is $3 million and S is $7 million. The bonds have a 14 per-
cent yield to maturity, and the stock is expected to pay $500,000 in dividends this year.The
growth rate of dividends has been 11 percent and is expected to continue at the samerate.
Find the cost of capital if the corporation tax rate on income is 40 percent
Solution:1. Compute the After-Tax Cost of Debt:
k1 (1 - t) = 0.14 * (1 - 0.4) = 0.14 * 0.6 = 0.084 or 8.4%
2. Compute the Cost of Equity (Dividend Discount Model):
ke = (D1 / P0) + g
ke = (500,000 / 7,000,000) + 0.11 = 0.0714 + 0.11 = 0.1814 or 18.14%
3. Compute WACC:
k = (3 / (3 + 7)) * 0.084 + (7 / (3 + 7)) * 0.1814
k = 0.3 * 0.084 + 0.7 * 0.1814 = 0.0252 + 0.12698 = 0.15218 or 15.22%
3. On January 1, 20X1, International Copy Machines (ICOM), one of the favorites of the stock
market, was priced at $300 per share. This price was based on an expected dividend at the
end of the year of $3 per share and an expected annual growth rate in dividends of 20
percent into the future. By January 20X2, economic indicators have turned down, and
investors have revised their estimate for future dividend growth of ICOM downward to 15
percent. What should be the price of the firm's common stock in January 20X2?
Assume the following:a. A constant dividend growth valuation model is a reasonable
representation of the way the market values ICOM. b. The firm does not change the risk
complexion of its assets nor its financial leverage. c. The expected dividend at the end of
20X2 is $3.45 per share. The constant dividend growth model gives the stock price P0 as:
P0 = D1 / (ke - g)
where: - D1 = Expected dividend at the end of 20X2 = $3.45
- g = New growth rate = 15%
To find the implied cost of equity ke from the initial conditions in 20X1:
300 = 3 / (ke - 0.20)
ke - 0.20 = 3 / 300 = 0.01
ke = 0.21 or 21%
Using ke = 21% and g = 15% for 20X2:
P0 = 3.45 / (0.21 - 0.15) = 3.45 / 0.06 = 57.5
4. K-Far Stores has launched an expansion program that should result in the saturation of
the Bay Area marketing region of California in six years. As a result, the company is
predicting a growth in earnings of 12 percent for three years and 6 percent for the fourth
through sixth years, after which it expects constant earnings forever. The company expects
to increase its annual dividend per share, most recently $2, in keeping with this growth
pattern. Currently, the market price of the stock is $25 per share. Estimate the company’s
cost of equity capital.
The stock follows a non-constant growth rate, so we use a two-stage Dividend Discount
Model:
1. Dividends for Each Stage:
- D0 = 2
- Years 1-3 (12% growth):
- D1 = 2 * 1.12 = 2.24
- D2 = 2.24 * 1.12 = 2.5088
- D3 = 2.5088 * 1.12 = 2.80986
- Years 4-6 (6% growth):
- D4 = 2.80986 * 1.06 = 2.9785
- D5 = 2.9785 * 1.06 = 3.1572
- D6 = 3.1572 * 1.06 = 3.3467
2. Constant Growth Beyond Year 6:
- Assume dividends grow at 6% forever after Year 6.
- The terminal value at the end of Year 6 is:
TV = (D6) / (ke - g) = (3.3467 * 1.06) / (ke - 0.06)
3. Present Value of Dividends and Terminal Value:
Calculate the present values of the dividends and solve for ke so that the total present
value equals $25.
