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20 Jul 2018

Estimating Components of both WACC and DDM

Analysts estimate the cost of debt capital for Abbott Laboratories (NYSE: ABT) is 2.13% and that its cost of equity capital is 4.1%. Assume that ABT's marginal tax rate is 36%, the risk-free rate is 5.3%, the market risk premium is 5.7%, the ABT market price is $47.73 per common share, and its dividends are $1.26 per common share.

(a) Compute ABT's average borrowing rate and its market beta. (Round your answers to one decimal place.)
Average borrowing rate = Answer%
Market beta = Answer

(b) Assume that its dividends continue at the current level in perpetuity. Use the constant perpetuity dividend discount model to infer the market's expected cost of equity capital. (Hint: Use Price per share = Dividends per share/Cost of equity capital.) (Round your answer to one decimal place.)
Answer%

(c) Compare the inferred cost of equity capital from part (b) to the 4.1% estimated cost of equity capital from analysts.

The inferred cost of equity capital seems high compared to 4.1%, which suggests that the investment has a negative beta.

The inferred cost of equity capital seems low compared to 4.1%, which suggests that the investment has a negative beta.

The inferred cost of equity capital seems high compared to 4.1%, which suggests that the investment has a positive beta.

The inferred cost of equity capital seems low compared to 4.1%, which suggests that the investment has a positive beta.

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Jean Keeling
Jean KeelingLv2
21 Jul 2018

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M12-22. Estimating Weighted Average Cost of Capital. Assume that a company has $1 billion in preferred stock and $3 billion in common stock. Also, it pays 6% dividends on preferred stock and its cost of equity capital is 7%. The company has no debt. Compute the company’s WACC.

M12-23. Estimating Company Value Using DDM with Constant Perpetuity. Assume that a company’s dividends per share are projected to remain at $1.20 each year, and that its cost of equity capital is 5%. Estimate the company’s per share stock price.

M12-25. Estimating Company Value Using DDM with Increasing Perpetuity. Assume that a company’s dividends per share are projected to grow at 2% each year, its next year’s dividends per share is $1.20, and its cost of equity capital is 5%. Estimate the company’s per share stock price.

M12-26. Estimating Company Value Using DDM with Increasing Perpetuity. Assume that a company paid $1.20 dividend per common share, its dividend per share is expected to grow at a constant rate of 2%, and its cost of equity capital is 5%. Estimate the company’s per share stock price.

part A. MNO's capital structure includes bonds, preferred stock, and common stock. The target capital structure calls for 50 percent common stock, 13 percent preferred stock, and the remainder as bonds. The company's bonds have a yield to maturity of 6.5 percent. The company's preferred stock, which sells for $68.59 per share, pays an annual dividend of $6.14. The market risk premium for the average common stock is 12.2 percent and the risk-free rate is 3.7 percent. MNO stock has a beta of 1.9. If MNO's marginal tax rate is 40 percent, then what is MNO's weighted average cost of capital? (Show your answer in decimal for to three places, e.g., 12.3% would be entered as 0.123)

part B.

ABC's capital structure is limited to common equity and bonds. Its target capital structure calls for 75 percent common equity and the rest long term debt. The company's outstanding bonds have a yield to maturity of 4.2 percent. The market risk premium for the average common stock is 7.6 percent, and the risk-free rate on US Treasuries is 4.1. ABC's beta is 1.18. Given its tax rate of 40 percent, what is ABC's weighted average cost of capital? (Show your answer in decimal for to three places, e.g., 12.3% would be entered as 0.123)


part C. XYZ has a target capital structure of 31 percent common equity and the rest long term debt. The company's outstanding bonds have a yield to maturity of 7.5 percent. The company's common stock sells for $82.56 per share and are expected to pay a dividend of $1.58 this year. Those dividends are expected to continue to grow at a constant rate of 8.7 percent. Given its tax rate of 40 percent, what is XYZ's weighted average cost of capital? (Show your answer in decimal for to three places, e.g., 12.3% would be entered as 0.123)

1. In Chapter 8 Figure 8.1 (known as the market line or the risk return trade off line) why should a company reject investment opportunities lying below the market line and accept those lying above the market line ?

2. How will an increase in financial leverage affect a company's cost of equity capital ? How will it affect a company's beta equity ?

3. Waste Management's annual dividend is $1.50 / share and its current stock price is $44.50. Assuming a 4% annual growth rate in dividends, what is Waste Management's cost of equity ?

4. The Coca-Cola Company's beta is 0.73. The long-term government bond rate is 2.0%. Assuming 6.3% for the historical excess return on common stocks, what is Coca-Cola's cost of equity capital ?

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