FIN 3320 West Texas A&M College

F I N 3 3 2 0 W E S T T E X A S A M T H E C O L L E G E O F

F I N 3 3 2 0 W E S T T E X A S A M T H E C O L L E G E O F, F I N . W e s t T e x a s A & M . T he C ollege of Business P | 1 © === Vitaliy Skorodziyevskiy ===All rights reserved. Homework 3 FINANCE 3320 Spring . Calculate the stock’s expected return, standard deviation, and coefficient of variation Demand for the Company’s Products Probability of This Demand Occurring Rate of Return if This Demand Occurs Weak 0.15 (30%) Below average 0.20 (3%) Average 0.35 18% Above average 0.20 25% Strong 0.10 31% 2.

Jackson Corp.’s common stock currently trades at $47.21 a share. It is expected to pay an annual dividend of $2.23 a share at the end of year (D1= $2.25), and the constant growth rate is 7.5% a year. a. What is the company’s cost of common equity if all of its equity comes from retained earnings? b. If the company issued new stock, it would incur a 8.5% floatation cost. What would be the cost of equity from new stock? c.

What is the floatation cost adjustment? 3. Your company estimates its WACC. You know the following information: a. The company’s capital structure consists of 60% common equity and 40% debt b.

Tax rate is 40% c. Your company has 20-year bonds outstanding with a 9%annual coupon and currently that bond is trading at par d. 5.5% is the risk-free rate e. 5% is the market risk premium f. 1.4 – is the company stock’s beta Calculate the company’s WACC.

4. The WACC is 7.5%. Project Investment NPV IRR A .99 14% B % C % D .4% a. Based on NPV which project or projects would you select? Projects are mutually exclusive. b.

Based on NPV which project or projects would you select? Projects are independent. c. Based on IRR which project or projects would you select? Projects are mutually exclusive. d. Based on IRR which project or projects would you select?

Projects are independent. e. Based on NPV and IRR which project or projects would you select? Projects are mutually exclusive. f. Based on NPV and IRR which project or projects would you select? Projects are independent.

Paper For Above instruction

The given assignment encompasses various financial analysis tasks, including the calculation of expected return, standard deviation, and coefficient of variation for a company's demand scenario, as well as the evaluation of a stock's cost of equity, the impact of flotation costs, and determining the company's Weighted Average Cost of Capital (WACC). Additionally, it involves analyzing investment projects based on Net Present Value (NPV) and Internal Rate of Return (IRR). This comprehensive approach facilitates effective financial decision-making and capital budgeting.

Expected Return, Standard Deviation, and Coefficient of Variation

To analyze the demand for the company's products, we start by calculating the expected return. Using the probabilities and corresponding rates of return provided, the expected return (E[R]) is calculated as the weighted average of possible returns:

E[R] = Σ (Probability of demand × Rate of return)

Substituting the provided values:

  • Weak demand: 0.15 × -30% = -4.5%
  • Below average: 0.20 × -3% = -0.6%
  • Average: 0.35 × 18% = 6.3%
  • Above average: 0.20 × 25% = 5%
  • Strong: 0.10 × 31% = 3.1%

Adding these gives: E[R] = -4.5% - 0.6% + 6.3% + 5% + 3.1% = 9.3%

Next, the standard deviation measures the variability of returns around the expected return. The variance is computed by summing the weighted squared deviations from the expected return:

Var(R) = Σ [Probability × (Rate of return – E[R])²]

Calculating each deviation squared:

  • Weak: (-30% - 9.3%)² = (−39.3%)² = 1544.49
  • Below average: (−3% - 9.3%)² = (−12.3%)² = 151.29
  • Average: 18% – 9.3% = 8.7%; squared = 75.69
  • Above average: 25% – 9.3% = 15.7%; squared = 246.49
  • Strong: 31% – 9.3% = 21.7%; squared = 470.89

Weighted sum of squared deviations:

  • Weak: 0.15 × 1544.49 = 231.67
  • Below average: 0.20 × 151.29 = 30.26
  • Average: 0.35 × 75.69 = 26.49
  • Above average: 0.20 × 246.49 = 49.30
  • Strong: 0.10 × 470.89 = 47.09

Variance = sum of the above = 385.00, thus standard deviation (σ) ≈ √385 ≈ 19.62%

The coefficient of variation (CV) is calculated as:

CV = σ / E[R] = 19.62% / 9.3% ≈ 2.11

These metrics provide insights into demand uncertainty and risk associated with the company's products.

Cost of Equity and Flotation Costs

The cost of common equity calculated via the Dividend Discount Model (DDM) is based on the dividend expected next year (D1) and the current stock price (P0), along with the growth rate (g):

Cost of Equity (rs) = (D1 / P0) + g

Using D1 = $2.25, P0 = $47.21, g = 7.5%:

rs = ($2.25 / $47.21) + 0.075 ≈ 0.0477 + 0.075 = 0.1227 or 12.27%

If the company issues new stock, it incurs flotation costs of 8.5%. The cost of equity from new stock (rs_new) accounts for these costs as:

rs_new = [(D1 / P0) + g] / (1 - flotation cost)

rs_new = 0.1227 / (1 - 0.085) ≈ 0.1227 / 0.915 ≈ 0.134 or 13.4%

The flotation cost adjustment reflects the additional cost of raising new equity, which affects the company's cost of capital for new projects or financing.

Calculating WACC

The weighted average cost of capital (WACC) incorporates the cost of equity and debt, adjusted for the company's capital structure and tax rate. The company's debt is priced at par, with a coupon rate of 9%, so the yield to maturity (YTM) equals the coupon rate.

Cost of debt (after tax) = YTM × (1 – Tax rate) = 0.09 × (1 – 0.40) = 0.054 or 5.4%

The cost of equity (rs) calculated earlier is approximately 12.27%. The weights are 60% equity and 40% debt:

WACC = (E/V) × rs + (D/V) × rd × (1 – Tax rate)

WACC = 0.60 × 0.1227 + 0.40 × 0.054 ≈ 0.0736 + 0.0216 = 0.0952 or 9.52%

This WACC reflects the company's overall cost of capital considering its capital structure and applicable taxes.

Project Evaluation Using NPV and IRR

Given a WACC of 7.5%, and the projects with respective NPVs and IRRs:

  • Project A: NPV = 0.99, IRR = 14%
  • Project B: NPV undefined in the prompt, IRR not specified
  • Project C: NPV undefined, IRR not specified
  • Project D: NPV = 0.4, IRR not specified

Assuming the missing values for B and C are to be calculated or are provided elsewhere, the selection strategies are as follows:

  1. Mutually exclusive projects based on NPV: projects with positive NPVs should be accepted; among negatives, none should be accepted. The highest NPV indicates the best project.
  2. Independent projects based on NPV: accept all with positive NPV.
  3. Mutually exclusive projects based on IRR: accept the project with the highest IRR exceeding the WACC, which is 7.5%.
  4. Independent projects based on IRR: accept all IRRs exceeding the WACC.

Based on the data, Project A's IRR (14%) exceeds WACC, so it should be accepted. Similarly, if Project D's NPVs are positive, it should also be accepted, but without full data, precise recommendations can't be made.

Conclusion

This analysis illustrates how financial metrics like expected return, standard deviation, coefficient of variation, cost of equity, and WACC play crucial roles in capital budgeting and investment decisions. Proper application of NPV and IRR ensures optimal project selection aligned with corporate financial strategy. Accurate calculation and interpretation of these metrics support sustainable growth and value maximization for firms.

References

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