Rate Of Return For Stocks And Bonds

Rate Of Return For Stocks And Bonds

Calculate the following problems and provide an overall summary of how companies make financial decisions in no more than 700 words, based on your answers: 3. Stock Valuation: A stock has an initial price of $100 per share, paid a dividend of $2.00 per share during the year, and had an ending share price of $125. Compute the percentage total return, capital gains yield, and dividend yield. 4. Total Return: You bought a share of 4% preferred stock for $100 last year. The market price for your stock is now $120. What was your total return for last year? 5. CAPM: A stock has a beta of 1.20, the expected market rate of return is 12%, and a risk-free rate of 5 percent. What is the expected rate of return of the stock? 6. WACC: The Corporation has a targeted capital structure of 80% common stock and 20% debt. The cost of equity is 12% and the cost of debt is 7%. The tax rate is 30%. What is the company's weighted average cost of capital (WACC)? 7. Flotation Costs: Medina Corp. has a debt-equity ratio of 0.75. The company is considering a new plant that will cost $125 million to build. When the company issues new equity, it incurs a flotation cost of 10 percent. The flotation cost on new debt is 4 percent. What is the initial cost of the plant if the company raises all equity externally? Submit your summary and all calculations.

Paper For Above instruction

Financial decision-making within companies hinges on accurately assessing the returns on various instruments and understanding how these impact valuation, capital structure, and overall corporate strategy. This paper explores the key calculations involved in evaluating stock returns, the application of capital asset pricing models, the determination of weighted average cost of capital, and the impact of flotation costs when raising new equity or debt. The comprehensive analysis demonstrates how these financial concepts guide companies in optimizing their financing strategies and investment decisions.

Stock Valuation and Return Analysis

The initial stock valuation involves calculating the total return, dividend yield, and capital gains yield based on given figures. A stock purchased at $100, paying a dividend of $2.00 during the year, with an end-of-year price of $125, provides a foundation for these calculations. The dividend yield is derived from the dividend relative to the initial price, hence:

  • Dividend Yield = ($2 / $100) = 2%

The capital gains yield reflects the increase in stock price over the initial purchase price, calculated as:

  • Capital Gains Yield = (($125 - $100) / $100) = 25%

The total return combines both income and capital appreciation:

  • Total Return = Dividend Yield + Capital Gains Yield = 2% + 25% = 27%

These calculations emphasize the importance of both dividends and price appreciation in assessing stock performance. Companies strategize to enhance these returns through dividend policies and stock price management, directly influencing investor perceptions and company valuation.

Total Return on Preferred Stock

For preferred stock purchased at $100 with a 4% annual dividend, the dividend payments amount to $4 per share. The stock's market price increase to $120 results in a return calculated as follows:

  • Total Return = (Dividend + Price Appreciation) / Initial Price = ($4 + $20) / $100 = 24%

This return indicates a strong investor incentive for holding preferred stock, which companies utilize for stable financing. Firms consider such investments in their capital structure, balancing cost and risk.

Capital Asset Pricing Model (CAPM)

The expected return of a stock, according to CAPM, accounts for systematic risk through beta. Given a beta of 1.20, a market return of 12%, and a risk-free rate of 5%, the expected return is:

Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)


= 5% + 1.20 × (12% - 5%) = 5% + 1.20 × 7% = 5% + 8.4% = 13.4%

This prediction informs investors and firms about the requisite rate of return to compensate for risk, influencing stock valuation and investment eligibility.

Weighted Average Cost of Capital (WACC)

The WACC calculation combines the costs of equity and debt, weighted by their proportions, adjusted for tax benefits of debt. With a target capital structure of 80% equity and 20% debt, costs of 12% and 7%, and a 30% tax rate, the WACC is:

WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)


= 0.80 × 12% + 0.20 × 7% × (1 - 0.30)


= 0.80 × 0.12 + 0.20 × 0.07 × 0.70


= 0.096 + 0.0098 = 0.1058 or 10.58%

This cost of capital guides firms in project evaluation and capital investment decisions, balancing risk and return considerations.

Impact of Flotation Costs

When raising new equity and debt to finance a $125 million plant, flotation costs impact the initial capital needed. With a debt–equity ratio of 0.75, flotation costs of 10% on equity and 4% on debt, the effective initial cost when issuing entirely new equity is calculated by adjusting for flotation fees:

Cost of raising equity = Flotation cost / (1 + Debt-Equity Ratio) + Flotation cost on debt × (Debt / (1 + Debt))


= 10% × (1 / 1.75) + 4% × (0.75 / 1.75)


= 0.10 × 0.5714 + 0.04 × 0.4286


= 0.05714 + 0.01714 = 0.07428 or 7.43%


Initial cost = $125 million / (1 - 0.07428) ≈ $125 million / 0.92572 ≈ $135 million

This indicates the true initial expenditure required considering flotation fees, which influence project valuation and funding strategies.

Conclusion

Financial decision-making in corporations depends heavily on accurately analyzing returns, risks, and costs associated with various financing options. Stock valuation reveals how dividends and capital gains combine to produce total returns, informing investment strategies. The CAPM provides a systematic approach to understanding expected returns based on market risk, aiding in valuation and risk management. The WACC calculation illustrates how firms balance debt and equity to optimize their cost of capital, directly affecting investment and growth initiatives. Additionally, acknowledging flotation costs ensures corporations accurately determine capital requirements for large projects, influencing feasibility assessments and strategic planning. Collectively, these financial metrics enable companies to make informed, strategic decisions that enhance value maximization and sustain competitive advantage.

References

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