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Karlo Corporation: What is Karlo's expected dividend next year? What should be Karlo's cost of capital?

Karlo Corporation is considering an initial public offering. Other firms in the same mature industry as Karlo (each of whom has traded publicly for at least five years) include the following. Each of these firms (including Karlo) has negligible levels of debt. Also listed is the Standard & Poors 500, an index of large US stocks. Since Karlo is not yet publicly traded, no historical price data is available for it; thus, it is not listed below.

Firm Beta Volatility
Groucho .60 40%
Chico .55 35%
Harpo .80 45%
Zeppo .75 45%
Gummo .80 35%
S&P index 1.00 20%

Short-term interest rates are 4.0%, Inflation is expected to be 3.0%. Karlo is estimated to earn $1.00 per share next year. Karlo plans to reinvest only 10% (thus, paying out 90%) of its earnings; its growth in earnings [and therefore in dividends] is expected only to keep pace with inflation.

A. What is Karlo's expected dividend next year?
B. What should be Karlo's cost of capital?
C. What should be Karlo's stock price?

D. Karlo is considering using 25% debt in its capital structure. If it decided to do so, what would this do to the risk of its equity, as measured by stock beta (increase, decrease, leave unchanged)?

Solution Preview

A. What is Karlo's expected dividend next year?

Karlo's EPS next year = 1.00
Retained earning = 10% * 1 = 0.10
Dividend payout next year is D1 = EPS - Retained earning = 1- 0.10 = $0.90

B. What should be Karlo's cost of capital?

The cost of capital is the required return necessary to make a capital budgeting project worthwhile. It include the cost of debt and the cost of equity.
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if they invested their money someplace else with similar risk.
In this case, the cost of capital is the interest rate in the short-term market. ...

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