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FIN 571 UP Economics Stock Valuation & Total Return Questions

FIN 571 UP Economics Stock Valuation & Total Return Questions

ANSWER

Stock Valuation:

  1. Percentage Total Return = [(Ending Share Price – Initial Share Price + Dividends) / Initial Share Price] * 100 = [($125 – $100 + $2) / $100] * 100 = 27%
  2. Capital Gains Yield = (Ending Share Price – Initial Share Price) / Initial Share Price = ($125 – $100) / $100 = 25%
  3. Dividend Yield = Dividend / Initial Share Price = $2 / $100 = 2%

Total Return: Total Return = (Ending Market Price – Initial Investment) / Initial Investment = ($120 – $100) / $100 = 20%

CAPM (Capital Asset Pricing Model): Expected Rate of Return = Risk-Free Rate + Beta * (Market Rate of Return – Risk-Free Rate) = 5% + 1.20 * (12% – 5%) = 5% + 1.20 * 7% = 5% + 8.4% = 13.4%

WACC (Weighted Average Cost of Capital): WACC = (E/V) * Re + (D/V) * Rd * (1 – Tax Rate) Where: E = Market Value of Equity V = Market Value of the Firm (E + D) Re = Cost of Equity D = Market Value of Debt Rd = Cost of Debt

Given: Cost of Equity (Re) = 12% Cost of Debt (Rd) = 7% Tax Rate = 30% Targeted Capital Structure: 80% Equity, 20% Debt

Assuming the total market value is $100 (for simplicity): E = 0.80 * $100 = $80 D = 0.20 * $100 = $20

WACC = (80/100) * 0.12 + (20/100) * 0.07 * (1 – 0.30) = 0.096 + 0.014 * 0.70 = 0.1052 or 10.52%

Flotation Costs: When raising equity: Flotation Cost on Equity = 10% Initial Cost of Equity = Cost of Equity / (1 – Flotation Cost on Equity) = 12% / (1 – 0.10) = 12% / 0.90 = 13.33%

Initial Cost of Plant = $125 million (since all equity is raised externally)

Please note that the above calculations are simplified and may not account for all real-world complexities. Companies make financial decisions based on these calculations to understand potential returns, costs, and risks associated with various investment and financing choices. These decisions help in maximizing shareholder wealth and achieving strategic goals while managing financial resources effectively.

FIN 571 UP Economics Stock Valuation & Total Return Questions

QUESTION

Description

ASSIGNMENT STEPS

Calculate the following problems and provide an overall summary of how companies make financial decisions based on your answers:

  1. Stock Valuation: A stock has an initial price of $100 per share, paid a dividend of $2.00 per share during the year, and had an ending share price of $125. Compute the percentage total return, capital gains yield, and dividend yield.
  2. Total Return: You bought a share of 4% preferred stock for $100 last year. The market price for your stock is now $120. What was your total return for last year?
  3. CAPM: A stock has a beta of 1.20, the expected market rate of return is 12%, and a risk-free rate of 5 percent. What is the expected rate of return of the stock?
  4. WACC: The Corporation has a targeted capital structure of 80% common stock and 20% debt. The cost of equity is 12% and the cost of debt is 7%. The tax rate is 30%. What is the company’s weighted average cost of capital (WACC)?
  5. Flotation Costs: Medina Corp. has a debt-equity ratio of .75. The company is considering a new plant that will cost $125 million to build. When the company issues new equity, it incurs a flotation cost of 10%. The flotation cost on new debt is 4%. What is the initial cost of the plant if the company raises all equity externally?
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