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Cost of Internal Equity Capital and External Equity Capital

1.The common stock for Grapevine Plumbing Company currently sells for $40 per share. If a new issue is sold, the flotation cost is estimated to be $7 per share. The company had earnings of $2.00 per share four years ago. Next year, the company expects to have earnings of $3.22 per share. The company maintains a constant dividend payout ratio of 40%. Earnings per share are anticipated to grow at the same rate in the future. The firm's marginal tax rate is 30%. Calculate the cost of internal equity capital and external equity capital.

2.Hauber, Ltd., is negotiating a line of credit with bank A, B, and C, each of which has the following terms:

A.prime with interest on a discounted interest basis and a 20% compensating
balance requirement on the face amount of the loan.
B.prime plus 2% with interest due at maturity and a 15% compensating balance
requirement on the face amount of the loan.
C.prime plus 1% with interest discounted and a 15% compensating balance requirement on the face amount of the loan.

The prime rate of interest is currently at 8.5%. What is the effective rate of interest for each bank? Recommend which bank's line of credit Hauber, Ltd. should accept? Why?

3.Patterson, Inc. is considering a new production line for its rapidly expanding equipment division. The new line will cost $480,000, and will be depreciated on a straight-line basis over the next three years leaving no residual value. Other important factors are:

-new sales for each of the next 3 years will be $465,000, $560,000, and $610,000
-cost of goods sold exclusive of depreciation is 40% of sales
-increased General & Administrative and selling expenses are estimated to be $40,000 per year.
-the company's cost of capital is 14% with a tax rate of 40%

a.) What are the project's annual cash flows?

b.) What is the projects NPV?

4.The firm of Beck has two investment proposals that have been submitted to you for consideration. Given the following data, for each project calculate the required information and make a recommendation.
Proposal Jackson
P Return (%)
.25 10
.45 14
.30 10
Proposal Harley
P Return (%)
.25 5
.55 10
.20 20

a. Expected Return J____ H______
b. Standard deviation J______ H______
c. Coefficient of variation J_____ H_____

5. Omar Corp issued just issued a 10 percent, 20 year bond with a $1000 par value that pays interest semi-annually.

a. How much can the investor expect in annual interest (in dollars)?

b. How much can the investor expect in interest every six months?

c. How much can the investor expect in par value at the end of the 20 years?

Solution Preview

1.The common stock for Grapevine Plumbing Company currently sells for $40 per share. If a new issue is sold, the flotation cost is estimated to be $7 per share. The company had earnings of $2.00 per share four years ago. Next year, the company expects to have earnings of $3.22 per share. The company maintains a constant dividend payout ratio of 40%. Earnings per share are anticipated to grow at the same rate in the future. The firm's marginal tax rate is 30%. Calculate the cost of internal equity capital and external equity capital.

P0 = $40
Floatation cost is F = $7
EPS(-4) = 2
EPS(1) = $3.22
dividend payout ratio = 40%
t = 30%

First, we compute the compound annual growth rate
g = [EPS(1)/EPS(-4)]^(1/years)-1
g =(3.22 / 2)^(1/5) -1
g = 0.10

Dividend in the next year will be
D1 = EPS(1)* dividend payout ratio = 3.22*40% = $1.29

Using DDM, the cost of internal equity is
K = D1 / P0 + g = 1.29/40 + 0.10 = 0.132 = 13.2%

Considering the floatation cost, the cost of external equity is
K = D1/(P0-F) + g = 1.29/(40-7) + 0.10 = 0.139 = 13.9%

2. Hauber, Ltd., is negotiating a line of credit with bank A, B, and C, each of which has the following terms:
A. prime with interest on a discounted interest basis and a 20% compensating balance requirement on the face amount of the loan.
B. prime plus 2% with interest due at maturity and a 15% compensating balance requirement on the face amount of the loan.
C. prime plus 1% with interest discounted and a 15% compensating balance requirement on the face amount of the loan.
The prime rate of interest is currently at 8.5%. What is the effective rate of interest for each bank? Recommend which bank's line of credit Hauber, Ltd. should accept? Why?

A discounted ...

Solution Summary

The solution determines the cost of internal equity capital and external equity capital.

$2.19