A) Firm A is an all equity financed firm. Its current equity price is £1.06 cum dividend. Also, its current earnings per share (eps) and current dividend payment are 20p and 12p, respectively. The market expects the ratio of eps to dividend to stay the same in the future. Firm A's rate of return on reinvested funds is equal to its equity cost of capital. Estimate firm A's cost of capital.

b) Firm B has the same business risk as firm A and it is also all equity financed. Firm B's current market capitalization is £25 million. It makes no profit currently, but is expected to make a constant profit of £1 million two and three years from now. All profits are paid out as dividends in the second and third years. After that profits grow at a constant rate forever, allowing the firm to pay out £1 million in dividends in year four and retaining 50% of the profits. From then on Firm B plans to retain the same fraction of profits each year and return the remainder to shareholders. Estimate firm B's rate of return on reinvested funds.

c) Firm C also has the same business risk as firm A, however it is a levered company: C's book value ratio of debt to equity is 1/4 and market value ratio of debt to equity is 1/3. The market risk premium is 6% and the risk free interest rate is 3%. Firm C's debt beta is 0.2. Assuming that CAPM holds and corporate tax is 0%, estimate firm C's equity cost of capital.

d) What is firm C's cost of capital if corporate tax is 30%?

Solution Summary

Cost of capital, return on reinvested funds, equity cost of capital for levered and unlevered firms have been calculated.

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