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Assessing Capital Structure

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1. The corporate treasurer of Ajax Company expects the company to grow at 4% in the future, and debt securities at 6% interest (tax rate = 30%) to be a cheaper option to finance the growth. The current market price per share of its common stock is $39, and the expected dividend in one year is $1.50 per share. Calculate the cost of the company's retained earnings and check if the treasurer's assumption is correct.

2. The risk-free rate on 10-year U.S. Treasury bills is 3% and the expected rate of return on the overall stock market is 11%.
The company has a beta of 1.6. What is the cost of equity?

3. A company has a capital structure as follows:
Total Assets $600,000
Debt $300,000
Preferred Stock $100,000
Common Equity $200,000

What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital?
Assume the applicable tax rate is 40%, interest on debt is 11%, flotation cost per share of preferred stock is $0.75, and
flotation cost per share of common stock is $4. The preferred and common stocks are selling in the market for $26 and $143 a share respectively, and they are expected to pay a dividend of $2 and $7, respectively, in one year. The company's dividends are expected to grow at 13% per year. The firm would like to maintain the existing capital structure to finance the new project.

4. Required rate of return is 10%.
Net Cash Flow
Year Project A Project B
0 -$2,000 -$2,500
1 $900 $1,500
2 $1,100 $1,300
3 $1,300 $800

a) Calculate the payback period for each project.
b) Calculate the net present value for each project.
c) Which project do you think will be approved, if only one project can be approved? Why?
d) What if the required rate of return was 20%?

5. A corporate bond has a face value of $1,000 and an annual coupon interest rate of 7%. Interest is paid annually. 10 years of the life of the bond remain. The current market price of the bond is $872. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today?

6. Ajax Manufacturing is expected to pay a dividend of $8 per share next year.  The dividend growth rate is expected to continue to be 3%. Required rate of return is 14%.
a) What should be the current market price per share?
b) What is the annual rate of return if you purchase the stock at $65?

7. A common stock sells for $82 per share, has a growth rate of 7% and a dividend that was just paid of $3.82. What is the
annual percent yield per share?

8. A corporate bond has a face value of $1,000 and an annual coupon interest rate of 6%. Interest is paid annually. 12 years of the life of the bond remain. The current market price of the bond is $1,027, and it will mature at $1,100. To the nearest whole percent, what is the yield to maturity (YTM) of the bond today?

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Solution Summary

There are 8 problems related to different valuation and capital budgeting models in finance. Solutions to given problems depict the methodologies to determine cost of retained earnings, cost of debt, cost of preferred stock, WACC, NPV, IRR, and payback period.

Solution Preview

Please refer attached file for better clarity of tables and formulas in MS Excel.

Cost of debt=rd=6%
Tax Rate=T=30%
Cost of debt after tax=rd*(1-T)= 4.20%

Expected dividend=D1=$1.50
Growth Rate=g=4%
Price of common stock=Po=$39
Cost of retained earnings=(D1/Po)+g=(1.5/39)+4%=7.85%

Risk free rate=rf=3%
Market return=rm=11%
Cost of equity=rf+b*(rm-rf)=15.80%

Cost of debt=rd=11%
Tax Rate=T=40%
Cost of debt after tax=rd*(1-T)=6.60%

Price of preferred stock=Pp=$26
Flotation cost for preferred cost= $0.75
Flotation cost for preferred cost=Fd=Flotation cost/Price of preferred stock=0.75/26=2.88%
Expected dividend =Dp=$2

Cost of preferred stock=rp=Dp/((1-Fd)*Pp)=7.92%

Price of common stock=Pc=$143
Expected dividend=D1=$7
Growth rate=g=13%
% flotation cost=Fc=Flotation cost/Pc= 2.80%
Cost of retained earnings=rc=D1/((1-Fc)*Pc)+g=18.04%

Weight of Debt=wd=Debt/total assets=300000/600000=50.00%
Weight of Preferred stock=wp=Preferred stock/total assets=100000/600000= 16.67%
Weight of common stock=wc=common stock/total assets=200000/600000=33.33%


a) Calculate the payback period for each project.

Project A
Year Net Cash flow Cumulative cash Flow
0 -2000 -2000
1 900 -1100
2 1100 ...

Solution provided by:
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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