Stock Price, After Tax Cost of Debt and Leverage
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1) A stock that currently trades for $40 per share is expected to pay a year-end dividend of $2 per share. The dividend is expected to grow at a constant rate over time. The stock has a beta of 1.2, the risk-free rate is 5%, and the market risk premium is 5%. What is the stock's expected price seven years from today?
2) Maxvill Motors has annual sales of $15,000. Its variable costs equal 60% of its sales, and its fixed costs equal $1,000. If the company's sales increase 10%, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)?
3) S. Claus & Co. is planning a zero coupon bond issue that has a par value of $1,000 and matures in 2 years. The bonds will be sold today at a price of $826.45. If the firm's marginal tax rate is 40%, what is the annual after-tax cost of debt to the company on this issue?
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Solution Summary
This solution calculates the answers to three questions in an attached Excel file: stock's expected price, percentage increase in the company's earnings before interest and taxes (EBIT), annual after-tax cost of debt.
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1) A stock that currently trades for $40 per share is expected to pay a year-end dividend of $2 per share. The dividend is expected to grow at a constant rate over time. The stock has a beta of 1.2, the risk-free rate is 5%, and the market risk premium is 5%. What is the stock's expected price seven years from today?
Step 1: Calculate the required rate of return using CAPM
r= risk free rate + beta x market risk premium = 5% + 1.2 x 5%= 11.00%
Step 2: Calculate the growth rate of dividends using dividend discount model with constant growth
Po= Div1/ (r-g)
Dividend for next year= Div1 = $2.00
Cost of equity= r= 11.00% (calculated)
growth rate of dividends/earnings= g= ? ...
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