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Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of inflation
in the future. The real risk-free rate is equal to 3 percent and the market risk premium is
5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last 5 years.

kRF = k* + IP = 3% + 5% = 8%.
ks = 8% + (5%)2.0 = 18%.

Consider the following information for three stocks, Stock A, Stock B, and Stock C. The returns on each of the three
stocks are positively correlated, but they are not perfectly correlated. (That is, all of the correlation coefficients are
between 0 and 1.)

Expected Standard
Stock Return Deviation Beta
Stock A 10% 20% 1.0
Stock B 10 20 1.0
Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested in Stock B. Portfolio Q has one third
of its funds invested in each of the three stocks. The risk-free rate is 5 percent, and the market is in
equilibrium. (That is, required returns equal expected returns.) What is the market risk premium (kM -
kRF)?
Using Stock A (or any stock),
10% = kRF + (kM – kRF)bA
10% = 5% + (kM – kRF)1.0
(kM – kRF) = 5%.

A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5 percent.
What is the market risk premium?

12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043%  6.30%.

Company X has a beta of 1.6, while Company Y’s beta is 0.7. The risk-free rate is 7 percent, and the required rate
of return on an average stock is 12 percent. Now the expected rate of inflation built into kRF rises by 1 percentage
point, the real risk-free rate remains constant, the required return on the market rises to 14 percent, and betas
remain constant. After all of these changes have been reflected in the data, by how much will the required return
on Stock X exceed that on Stock Y?

bX = 1.6; bY = 0.7; kRF = 7%; kM = 12%.

Inflation increases by 1%, but k* remains constant. kRF increases by 1%; kM rises to 14%.

Before inflation change:

kX = 7% + 5%(1.6) = 15%.
kY = 7% + 5%(0.7) = 10.5%.

After inflation change:

kX = 8% + (14% - 8%)1.6 = 17.6%.
kY = 8% + (14% - 8%)0.7 = 12.2%.

kX - kY = 17.6% - 12.2% = 5.4%.

You hold a diversified portfolio consisting of a $10,000 investment in each of 20 different common stocks (that is,
your total investment is $200,000). The portfolio beta is equal to 1.2. You have decided to sell one of your stocks
that has a beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase another stock that has a beta
equal to 1.4. What will be the beta of the new portfolio?

1.2 = 1/20(0.7) + (19/20)b

b is average beta for other 19 stocks.
1.165 = (19/20)b.

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 New Beta = 1.165 + 1/20(1.4) = 1.235.

An investor is forming a portfolio by investing $50,000 in stock A that has a beta of 1.50, and $25,000 in stock B
that has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a yield of 4
percent. What is the required rate of return on the investor’s portfolio?

($50,000/$75,000)1.5 + ($25,000/$75,000)0.9 = 1.3. The required rate of return is then simply: 4% + (6%
- 4%)1.3 = 6.6%.

Bridges & Associates’ stock is expected to pay a $0.75 per-share dividend at the end of the year. The dividend is
expected to grow 25 percent the next year and 35 percent the following year. After t = 3, the dividend is expected to
grow at a constant rate of 6 percent a year. The company’s cost of common equity is 10 percent and it is expected to
remain constant.

Stock price--nonconstant growth

What is the expected price of the stock today?
First, we must find the explicit forecasted dividends:
D1 = 0.75
D2 = 0.9375 (0.75  1.25 = 0.9375)
D3 = 1.265625 (0.9375  1.35 = 1.265625)
D4 = 1.3415625 (1.265625  1.06 = 1.3415625)

Now, we need to determine the terminal value of the stock in Year 3, using the Year 4 dividend:

P̂3 = D4/(ks – g)
P̂3 = $1.3415625/(0.10 - 0.06)
P̂3 = $33.5390625.

$0.75 $0.9375 ($1.265625  $33.5390625

2
P0 = 1.10 + (1.10) + (1.10)3
= $0.6818 + $0.7748 + $26.1493
= $27.6059  $27.61.

Future stock price--constant growth

What is the expected price of the stock 10 years from today?
In 10 years, this stock will be a constant growth stock. Therefore, use the constant growth formula and find
the price in Year 10. In order to find the value in Year 10, determine the dividend in Year 11:
D11 = 0.75  1.25  1.35  (1.06)8 = $2.0172.

Now, calculate the stock price in Year 10:

P̂10 = D11/(ks – g)
P̂10 = $2.0172/(0.10 - 0.06)
P̂10 = $50.43.

(The following information applies to the next two problems.)

An analyst has put together the following spreadsheet to estimate the intrinsic value of the stock of Rangan Company
(in millions of dollars):

t=1 t=2 t=3

Sales $3,000 $3,600 $4,500
NOPAT 500 600 750
Net investment in operating capital* 300 400 500

*Net investment in operating capital = Capital expenditures + Changes in net operating capital – Depreciation.

After Year 3 (t = 3), assume that the company’s free cash flow will grow at a constant rate of 7 percent a year and the
company’s WACC equals 11 percent. The market value of the company’s debt and preferred stock is $700 million. The
company has 100 million outstanding shares of common stock.

Free cash flow

What is the company’s free cash flow the first year (t = 1)?

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 FCF1 = EBIT(1 - T) + Depreciation – ΔNOWC – Capital expenditures
= $500,000,000 - $300,000,000 = $200,000,000.

FCF model for valuing stock

Using the free cash flow model, what is the intrinsic value of the company’s stock today?

Using the FCF model, P̂3 = FĈF3 (1.07)/(0.11 – 0.07) = [($750 - $500) (1.07)]/0.04 = $6,687.50, which is the value
of the firm at t = 3 after the dividend is received.

So, the value of the firm today = $200/(1.11) + $200/(1.11)2 + ($250 + $6,687.50)/(1.11)3 = $5,415.1449 million
 $5,415 million.

This is the value of the total firm (debt, preferred stock, and equity), so the value of debt and preferred stock
must be deducted to arrive at the value of the firm’s common equity. The common equity has a value of
$5,415 million – $700 million = $4,715 million. So, the price/share = $4,715 million/100 million = $47.15.

An analyst is estimating the intrinsic value of the stock of Xavier Company. The analyst estimates that the stock will pay
a dividend of $1.75 a share at the end of the year (that is, D̂1 = $1.75). The dividend is expected to remain at this level
until 4 years from now (that is, D̂2 = D̂3 = D̂4 = $1.75). After this time, the dividend is expected to grow forever at a
constant rate of 6 percent a year (that is, D̂5 = $1.855). The stock has a required rate of return of 13 percent.

Nonconstant growth stock

What is the stock’s intrinsic value today? (That is, what is P̂0 ?)
P̂4 = D4(1 + g)/(ks – g) = $1.75(1.06)/(0.13 – 0.06) = $26.50.

P̂0 = $1.75/1.13 + $1.75/(1.13)2 + $1.75/(1.13)3 + ($1.75 + $26.50)/(1.13)4

P̂0 = $1.5487 + $1.3705 + $1.2128 + $17.3263
P̂0 = $21.4583  $21.46.

Future stock price--nonconstant growth

Assume that the forecasted dividends and the required return are the same one year from now, as those forecasted
today. What is the expected intrinsic value of the stock one year from now, just after the dividend has been paid at t =
1? (That is, what is P̂1 ?)
P̂1 = $1.75/1.13 + $1.75/(1.13)2 + ($1.75 + $26.50)/(1.13)3
P̂1 = $1.5487 + $1.3705 + $19.5787
P̂1 = $22.4979  $22.50.

New equity and equilibrium price

Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project. The
increase in shares will bring to 25 million the number of shares outstanding. Nahanni’s long-term growth rate is 6
percent, and its current required rate of return is 12.6 percent. The firm just paid a $1.00 dividend and the stock sells
for $16.06 in the market. When the new equity issue was announced, the firm’s stock price dropped. Nahanni
estimates that the company’s growth rate will increase to 6.5 percent with the new project, but since the project is
riskier than average, the firm’s cost of capital will increase to 13.5 percent. Using the DCF growth model, what is the
change in the equilibrium stock price?
D0 (1.06) $1.00(1.06)
P0, Old = 0.126 - 0.06 = 0.066 = $16.06.
$1.00(1 + gNew) $1.00(1.065) $1.065
P0, New = k̂s, New - gNew = 0.135 - 0.065 = 0.07 = $15.21.
Change in price = P15.21 – P16.06 = -P0.85.

Risk and stock value

The probability distribution for kM for the coming year is as follows:

Probability kM
0.05 7%
0.30 8
0.30 9
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 0.30 10
0.05 12

If kRF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and D0 = $2, what
market price gives the investor a return consistent with the stock’s risk?
Calculate required return on market and stock:
kM = 0.05(7%) + 0.30(8%) + 0.30(9%) + 0.30(10%) + 0.05(12%) = 9.05%.
ks = 6.05% + (9.05% - 6.05%)2.0 = 12.05%.

Calculate expected equilibrium stock price:

$2(1.07)
P̂0   $42.38.
0.1205  0.07

Beta coefficient
As financial manager of Material Supplies Inc., you have recently participated in an executive committee decision to
enter into the plastics business. Much to your surprise, the price of the firm’s common stock subsequently declined
from $40 per share to $30 per share. While there have been several changes in financial markets during this period,
you are anxious to determine how the market perceives the relevant risk of your firm. Assume that the market is in
equilibrium. From the following data you find that the beta value associated with your firm has changed from an old
beta of to a new beta of .

 The real risk-free rate is 2 percent, but the inflation premium has increased from 4 percent to 6 percent.
 The expected growth rate has been re-evaluated by security analysts, and a 10.5 percent rate is considered
to be more realistic than the previous 5 percent rate. This change had nothing to do with the move into
plastics; it would have occurred anyway.
 The risk aversion attitude of the market has shifted somewhat, and now the market risk premium is 3
percent instead of 2 percent.
 The next dividend, D1, was expected to be $2 per share, assuming the “old” 5 percent growth rate.

Calculate old required return and beta:

$2
ks(old) = $40 + 0.05 = 0.10.
0.10 = kRF + (RPM)bOld = 0.06 + (0.02)bOld; bOld = 2.00.

Calculate new required return and beta:

$2.00
Note that D0 = 1.05 = $1.90476.
D1,New = $1.90476(1.105) = $2.10476.
2.10476
ks(New) = $30 + 0.105 = 0.1752.
2.10476
ks(New) = $30 + 0.105 = 0.1752.

Stock price
You have been given the following projections for Cali Corporation for the coming year.

 Sales = 10,000 units.

 Sales price per unit = $10.
 Variable cost per unit = $5.
 Fixed costs = $10,000.
 Bonds outstanding = $15,000.
 kd on outstanding bonds = 8%.
 Tax rate = 40%.
 Shares of common stock outstanding = 10,000 shares.
 Beta = 1.4.
 kRF = 5%.
 kM = 9%.
 Dividend payout ratio = 60%.
 Growth rate = 8%.

Calculate the current price per share for Cali Corporation.

Step 1: Set up an income statement to find net income:

Sales $100,000 $10 10,000
Variable costs 50,000 $5 10,000
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 Fixed costs 10,000 (Given)
EBIT $ 40,000
Interest 1,200 0.08 $15,000
EBT $ 38,800
Taxes 15,520 0.40 $38,800
NI $ 23,280

Then, calculate the total amount of dividends, Div = Net income Payout = $23,280 0.6 =
$13,968.

Dividends/Share = Total dividend/# of shares outstanding

= $13,968/10,000 = $1.3968.

Note: Because these projections are for the coming year, this dividend is D1, or the dividend for
the coming year.

Step 2: Use the CAPM equation to find the required return on the stock:
kS = kRF + (kM - kRF)b = 0.05 + (0.09 - 0.05)1.4 = 0.106 = 10.6%.

Step 3: Calculate stock price:

P0 = D1/(kS - g)
= $1.3968/(0.106 - 0.08)
= $53.72.
Capital gains yield
Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of $20.00. Carlson’s
next dividend, D1, is forecasted to be $2.00, and Carlson is growing at an annual rate of
6 percent. Carlson has a beta coefficient of 1.2, and the required rate of return on the market is 15 percent. As
Carlson’s financial manager, you have access to insider information concerning a switch in product lines that would not
change the growth rate, but would cut Carlson’s beta coefficient in half. If you buy the stock at the current market
price, what is your expected percentage capital gain?

Step 1: Calculate ks, the required rate of return:

$2
ks = $20 + 6% = 10% + 6% = 16%.

Step 2: Calculate kRF, the risk-free rate:

16% = kRF + (15% - kRF)1.2
16% = kRF - 1.2kRF + 18%
0.2kRF = 2%
kRF = 10%.

Step 3: Calculate the new stock price and capital gain:

New ks = 10% + (15% - 10%)0.6 = 13%.
P̂New $2
= 0.13 - 0.06 = $28.57.
Therefore, the percentage capital gain is 43% calculated as follows:
$28.57 - $20.00 $8.57
$20.00 = $20.00 = 0.4285  43%.

Supernormal growth stock

Assume that the average firm in your company’s industry is expected to grow at a constant rate of 5 percent, and its
dividend yield is 4 percent. Your company is about as risky as the average firm in the industry, but it has just developed
a line of innovative new products, which leads you to expect that its earnings and dividends will grow at a rate of 40
percent (D1 = D0(1.40)) this year and 25 percent the following year after which growth should match the 5 percent
industry average rate. The last dividend paid (D0) was $2. What is the stock’s value per share?

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 Time line:
0 gks == 40%
9%
1 g2 = 25%
2 gn = 5%
3 Years
1
| | | |
2.00 2.80 3.50 3.675
P0 = ? 3.675
P̂2 = = 91.875
0.09  0.05
CFt 0 2.80 95.375

ks = Dividend yield + g = 0.04 + 0.05 + 0.09  9%.

Numerical solution:
$2.80 $95.375
P0    $82.84.
1.09 (1.09)2

Nonconstant growth stock

Holmgren Hotels’ stock has a required return of 11 percent. The stock currently does not pay a dividend but it expects
to begin paying a dividend of $1.00 per share starting five years from today (D5 = $1.00). Once established the dividend
is expected to grow by 25 percent per year for two years, after which time it is expected to grow at a constant rate of
10 percent per year. What should be Holmgren’s stock price today?

Time line:
0 ks = 11% 5 6 7 8 Years
|    | gs = 25%
|
gs = 25%
|
gn = 10%
|
P0 = ? 1.00 1.25 1.5625 1.71875

1.71875
P̂7 = 171.875 =
0.01
Step 1:
Determine the dividends to be received:
D5 = $1.00.
D6 = $1.00  1.25 = $1.2500.
D7 = $1.25  1.25 = $1.5625.
D8 = $1.5625  1.10 = $1.71875.

Step 2: Determine the value of the stock once dividend growth is constant:
D8
P̂7 
ks  g
$1.71875
P̂7 
0.11  0.10
P̂7  $171.875.

Step 3: Determine the price of the stock today:

As an investor today, you would be entitled to D5, D6, D7, and P̂7 .
Enter the following input data in your calculator:
CF0 = 0; CF1-4 = 0; CF5 = 1.00; CF6 = 1.25; CF7 = 1.5625 + 171.875 = 173.4375; I = 11; and then solve
for NPV = $84.80.

The Global Advertising Company has a marginal tax rate of 40 percent. The company can raise debt at a 12
percent interest rate and the last dividend paid by Global was $0.90. Global’s common stock is selling for $8.59
per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common
stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30
percent debt and 70 percent equity.

Cost of retained earnings

What is Global’s cost of retained earnings if it can use retained earnings rather than issue new common stock?

$0.90(1.05)
ks = $8.59 + 0.05 = 0.1600 = 16.00%.
Cost of external equity
What is the cost of common equity raised by selling new stock?

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 $0.90(1.05)
ke = $8.59(1 - 0.10) + 0.05 = 0.1722 = 17.22%.

WACC
What is the firm’s weighted average cost of capital if the firm has sufficient retained earnings to fund the equity portion
of its capital budget?

Since the firm can fund the equity portion of its capital budget with retained earnings, use ks in WACC.

WACC = wdkd(1 - T) + wcks

= 0.3(0.12)(1 - 0.4) + 0.7(0.16)
= 0.0216 + 0.112
= 0.1336 = 13.36%.

Byron Corporation’s present capital structure, which is also its target capital structure, is 40 percent debt and 60
percent common equity. Assume that the firm has no retained earnings. The company’s earnings and dividends are
growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is
$21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent
flotation cost will be incurred. The firm’s marginal tax rate is 40 percent.

Cost of external equity

What is the component cost of the equity raised by selling new common stock?

$2.00(1.05)
ke = $21.88(1 - 0.2) + 0.05 = 17%.

WACC
What is the firm’s weighted average cost of capital?

WACC = 0.4(0.14)(1 - 0.4) + 0.6(0.17) = 0.1356 = 13.56%  13.6%.

Rollins Corporation has a target capital structure consisting of 20 percent debt, 20 percent preferred stock, and 60
percent common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital
budget. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The
firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent
would be incurred. Rollins’ beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins
is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8
percent. The firm’s policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium
method to find ks. Flotation costs on new common stock total 10 percent, and the firm’s marginal tax rate is 40
percent.

Cost of debt
What is Rollins’ component cost of debt?

Time line:
0 kd/2 = ? 1 2 3 4 40 6-month
| | | | | • • • | Periods
PMT = 60 60 60 60 60
VB = 1,000 FV = 1,000

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost
of debt to Rollins is 12.0 percent. The after-tax cost of debt equals:
kd,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1000; PMT = 60; FV = 1000;
Output: I = 6.0% = kd/2.
kd = 6.0% 2 = 12%.
kd(1 - T) = 12.0%(0.6) = 7.2%.

Cost of preferred stock

What is Rollins’ cost of preferred stock?

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 Cost of preferred stock: kp = $12/$100(0.95) = 12.6%.

Cost of equity: CAPM

What is Rollins’ cost of retained earnings using the CAPM approach?

Cost of retained earnings (CAPM approach):

ks = 10% + (5%)1.2 = 16.0%.

Cost of equity: DCF

What is the firm’s cost of retained earnings using the DCF approach?

Cost of retained earnings (DCF approach):

$2.00(1.08)
ks = $27 + 8% = 16.0%.

Cost of equity: risk premium

What is Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium approach?

Cost of retained earnings (bond yield-plus-risk-premium approach):

ks = 12.0% + 4.0% = 16.0%.

WACC
What is Rollins’ WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget?

$2.00(1.08)
Calculate ke: ke = $27(1  0.1) + 8% = 16.89%.

WACC = wdkd(1 - T) + wpkp + wcke

= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.89%) = 14.09 14.1%.

The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to
grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected
return on the market is 14 percent. The firm’s investment bankers believe that new issues of common stock would
have a flotation cost equal to 5 percent of the current market price.

Stock price--constant growth

How much should an investor be willing to pay for this stock today?

ks = 10% + (4%)1.5 = 16%.

$3.00(1.10)
P0 = 0.16 - 0.10 = $55.00.

Cost of external equity

What will be Jackson’s cost of new common stock if it issues new stock in the marketplace today?

Cost of new common equity:

$3.30
ke = $55.00(0.95) + 0.10 = 16.32%.

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