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Required return for that company's stock

1. The 10 year US Treasury bond market rate is 5%, the stock market risk premium is 6%, and a company's beta is 1.5. Use the CAPM to calculate the required return for that company's stock; then briefly explain the logic of this calculation.

2. Keep all of the assumptions from quetion 1 and add the following:
The company has a management dictated target capital structure (market values) of 80% equity and 20% debt, a marginal tax rate of 40%, and the default premium on the company's debt of 2%. What is the WACC for the company?

3. Now assume that the company has two major segments with an equal size of operating assets. Segment A has a beta of 2.0 and Segment B has beta of 1.0. Each segment has the same debt target and pre-tax cost of debt. What is the WACC for each segment? if the company uses the total company WACC calculated in question 2 to make its investment decisions, what is the mistake it would make for Segment A ? What is the mistake it would make for Segment B?

Solution Preview

1. The 10 year US Treasury bond market rate is 5%, the stock market risk premium is 6%, and a company's beta is 1.5. Use the CAPM to calculate the required return for that company's stock; then briefly explain the logic of this calculation.
Cost of equity= Risk free rate + Beta * ( Market risk premium)
=5%+1.5*6%
= 14% =Answer

2. Keep all of the assumptions from question 1 and add the following :

The company has a management dictated target capital structure (market values) of 80% equity and 20% debt, a marginal tax ...

Solution Summary

Solution discusses and give the steps of computing required return for that company's stock

$2.19