BA350 Financial Management: Ch09 P18 Build a Model (Gao Computing)

BA350 Financial Management
Chapter 9. Solution for Ch 09 Build a Model

The stock of Gao Computing sells for $50, and last year's dividend was $2.10. A flotation cost of 10% would be required to issues new common stock.
Gao's preferred stock pays a dividend of $3.30 per share, and new preferred 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 also issue additional long-term debt at an interest rate (or 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 Gao's 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

P0 $50.00
Net Ppf $30.00
Dpf $3.30
D0 $2.10
g 7%
B-T rd 10%
Skye's beta 0.83
Market risk premium, RPM 6.0%
Risk free rate, rRF 6.5%
Target capital structure from debt 45%
Target capital structure from preferred stock 5%
Target capital structure from common stock 50%
Tax rate 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), the cost of equity (ignoring flotation costs) with the DCF method and the CAPM method.
Cost of debt
Cost of preferred stock (including flotation costs)
Cost of common equity, DCF (ignoring flotation costs)
Cost of common equity, CAPM
b. Calculate the cost of new stock using the DCF model.
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 DCF method, and add that differential to the CAPM value for rs.
d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company's 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. No new equity will be issued.
(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 company's situation and explain why each project should be accepted or rejected.
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