Answered: Use the following information about SV…

Managerial Accounting: The Cornerstone of Business Decision-Making

7th Edition

ISBN:9781337115773

Author:Maryanne M. Mowen, Don R. Hansen, Dan L. Heitger

Publisher:Maryanne M. Mowen, Don R. Hansen, Dan L. Heitger

Chapter15: Financial Statement Analysis

Section: Chapter Questions

Problem 66P

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Question

PLEASE START FROM SECTION C

INSTRUCTIONS:

Answer the following questions, using spreadsheet financial functions to do the calculations.

Use the following information about SV Inc. to calculate the company’s Cost of Capital.

The stock of SV Inc. sells for $50, and last year’s dividend was $2.10.
A flotation cost of 10% would be required to issue new common stock.
SVs’ preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share.
Security analysts are projecting that the common dividend will grow at a rate of 7% a year.
The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 35%. The market risk premium is 6%, the risk-free rate is 6.5%, and Supreme Ventures’ beta is 0.83.
In its cost-of-capital calculations, SV Inc. uses a target capital structure with 45% debt, 5% preferred stock, and 50% common equity.

REQUIRED:

SECTION A

Calculate the cost of each capital component:

i. the after-tax cost of debt

ii. the cost of preferred stock (including flotation costs)

iii. the cost of equity (ignoring flotation costs).

Use both the DCF(DGM) method and the CAPM method to find the cost of equity.

SECTION B

i. Calculate the cost of new stock using the DCF(DGM) model.

ii. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between r_e and r_s as determined by the DCF(DGM) method and then add that difference to the CAPM value for r_s.)

iii. Assuming that SV will not issue new equity and will continue to use the same target capital structure, what is the company’s WACC?

SECTION C

Suppose SV Inc. is evaluating three projects with the following characteristics:

i. Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from reinvested earnings.

ii. Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0%.

iii. Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0%.

iv. Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0%

Analyze the company’s situation and explain why each project should be accepted or rejected.

PLEASE START FROM SECTION C

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