Question 1:

Cox’s 12% bond with 15 years to maturity is currently selling for $1,153.72.
In order to derive the market interest rate, we can use RATE () function in excel.
Using N = 30 (semi-annually payments for 15 years), PV = -1153.72, PMT = 60, and we
assume FV = 1000. Hence, we derive Market interest rate = 5% and consider it as K d = 5%
Since this is a semiannual rate, multiply by 2 to find the annual rate, K d = 10%, the pre-tax cost
of debt.
Since interest is tax deductible and Cox’s relevant component cost of debt is the after-tax cost:
K d (1 – T) = 10% (1 – 0.40) = 10% (0.60) = 6.0%.

Question 2:

Given quarterly dividend = 10%

Since the preferred stock issue is perpetual, its cost is estimated as follows:
Dp 100∗0.1 10
Kp = = = = 0.090 = 9.0%.
P p 113.10−2 111.1
Since preferred dividends are not tax deductible, there is no need for a tax adjustment

Question 3:

The CAPM estimate for Cox’s cost of common equity:

k e = r f + (r m – r f ) β
= 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%.

Question 4:
Since Cox is a constant growth stock, the constant growth model can be used:
D1 D 0 (1+g)
k e= +g= +g
P0 P0

4.19(1+0.05)
= + 0.05
50

= 0.088 + 0.05

= 8.8% + 5.0%
 k e = 13.8%

Question 5:

Given ROE = 15%

Retention ratio = 35%

Hence, Payout ratio = 65% i.e. (1 – retention ratio)

Future Dividend growth rate = (1-Payout ratio) x (ROE)

= (1-0.65) x (0.15)

= 5.25%

Here, retention ratio defines the rate of earnings which the company retained in it and payout
ratio defines the rate of earnings which the company paid as dividends to its shareholders.

The earlier dividend growth rate was 5% which is less than the above calculated growth rate
5.25%. Hence, the calculated rate is inconsistent with the earlier rate.

The reason can be due to the changes in the retention and payout ratios, which cause a
difference in the dividend growth rate.

Question 6:

The cost of equity under bond-yield-plus-risk-premium method:

k e = Bond yield + Risk premium = 10.0% + 4.0% = 14.0%.
Here Bond yield is considered 10% as calculated in question 1.

Question 7:

The following table summarizes the k e estimates:

Method Estimate
CAPM 14.2%
DCF 13.8%
Bond-yield-plus-risk-premium 14.0%
Average 14.0%
For arriving at the final estimate of k e, we take the average of k e as per all the three methods
since its value is close in all the methods.
Question 8:

Cox’s Calculation of WACC:

Capital Structure
Weights  Costs = Product
Debt (After tax) 0.3 6% 1.8%
Preferred stock 0.1 9% 0.9%
Common Equity 0.6 14% 8.4%
1.0 WACC= 11.1%
WACC = wd k d (1 – T) + wp k p + we k e
= 0.3(10%) (0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.

Question 9:

We need to calculate k e first.

As per given data, Beta is 1.7

k e = r f + (r m – r f ) β
= 7.0% + (6.0%)1.7 = 7.0% + 10.2% = 17.2%.

Then we calculate the Cost of Capital of Cox;

Capital Structure
Weights  Costs = Product
Debt (After tax) 0.1 6% 0.6%
Common Equity 0.9 17.2% 15.48%
1.0 WACC= 16.68%
WACC = wd k d (1 – T) + we k e
= 0.1(10%) (0.6) + 0.9(17.2%)
= 0.6% + 15.48% = 16.68%.