Rate Of Return For Stocks And Bonds 713063

Rate Of Return For Stocks And Bondstop Of Formbottom Of Formassignment

The purpose of this assignment is to allow students to calculate the rate of return of equity and debt instruments, understand the effects of dividends, capital gains, inflation rates, and how the nominal rate of return affects valuation and pricing. Students will apply concepts related to CAPM, WACC, and Flotation Costs to examine the influence of debt and equity on a company's capital structure.

Students are required to perform various financial calculations including stock valuation, total returns, CAPM expected returns, WACC, and the impact of flotation costs. The assignment culminates in a summary of how companies make financial decisions in no more than 700 words, integrating the calculations and concepts applied.

Paper For Above instruction

Financial decision-making in corporations hinges on a comprehensive understanding of various financial metrics, including returns on stocks and bonds, capital structure, and associated costs of financing. Calculations such as stock valuation, return assessments, and the estimation of the weighted average cost of capital (WACC) serve as foundational tools to guide strategic investment and financing decisions. This paper synthesizes these concepts and demonstrates their critical role in corporate finance strategy.

Stock Valuation: Total Return, Capital Gains, and Dividend Yield

Consider a stock with an initial price of $100 per share that paid a dividend of $2.00 during the year and had an ending share price of $125. The total return combines dividend income and capital appreciation. The dividend yield is calculated as the dividend divided by the initial price, while the capital gains yield considers the change in share price relative to the initial price.

Dividend Yield = Dividend / Initial Price = $2 / $100 = 2%

Capital Gains Yield = (Ending Price - Initial Price) / Initial Price = ($125 - $100) / $100 = 25%

Total Return = Dividend Income + Capital Gains = 2% + 25% = 27%

This implies a 27% overall return, driven heavily by capital appreciation, with a modest contribution from dividends. Such returns influence investor confidence and valuation models and guide corporate dividend policies.

Total Return on Preferred Stock

When purchasing preferred stock at $100 with a 4% dividend, the annual dividend payment is $4 per share. If the market price of the stock rises to $120, the total return comprises both the dividend income and capital gain from price appreciation.

Total Return = (Dividend / Purchase Price) + (Price Change / Purchase Price) = ($4 / $100) + (($120 - $100) / $100) = 4% + 20% = 24%

This substantial return underscores the importance of understanding market movements and dividend policies for preferred stock investors, influencing company financing decisions and investor expectations.

Expected Return using CAPM

The Capital Asset Pricing Model (CAPM) estimates expected stock return based on systematic risk (beta), the risk-free rate, and the expected market return. Given a stock with a beta of 1.20, a risk-free rate of 5%, and an expected market return of 12%, the expected return is calculated as:

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 indicates that the stock's expected return exceeds the risk-free rate, reflecting its higher systematic risk, and influences investment decisions and risk assessments.

Calculating WACC

WACC reflects the average rate a company is expected to pay for financing from both equity and debt, adjusted for tax advantages. With a capital structure targeted at 80% equity (cost of 12%) and 20% debt (cost of 7%), and a tax rate of 30%, WACC is calculated as:

WACC = (E/V) Re + (D/V) Rd (1 - Tc) = 0.80 12% + 0.20 7% (1 - 0.30) = 9.6% + 0.20 7% 0.70 = 9.6% + 0.20 * 4.9% = 9.6% + 0.98% = 10.58%

The company's WACC of approximately 10.58% informs capital budgeting decisions and project evaluation thresholds, balancing the cost of debt’s tax shield against equity's risk premium.

Impact of Flotation Costs on New Plant Financing

Medina Corp plans to build a $125 million plant, raising all funds externally. Considering flotation costs—10% on equity and 4% on debt—the initial investment cost adjusts upward to account for these costs. Since the company intends to raise entirely through equity, the flotation costs directly increase the project's funding requirement.

Adjusted Cost = Cost / (1 - Flotation Cost) = $125 million / (1 - 0.10) = $125 million / 0.90 ≈ $138.89 million

Thus, the initial cost of the plant, considering flotation costs on equity, is approximately $138.89 million. This highlights the importance of flotation costs in project valuation and financing strategies, as they can significantly increase capital requirements.

Conclusion

These financial calculations form the backbone of strategic decision-making in corporations. Effective investment, financing, and valuation hinge upon accurate assessment of returns, risk, and costs associated with raising capital. From stock returns to cost of capital, each metric informs managers and investors about the potential profitability, risk exposure, and viability of projects and investments. Mastery of these concepts enables companies to optimize capital structures, manage risk, and maximize shareholder value, ultimately driving sustainable growth and competitive advantage.

References

  • Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management (15th ed.). Cengage Learning.
  • Damodaran, A. (2015). Applied Corporate Finance (4th ed.). Wiley.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Brealey, R., Myers, S., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Investopedia. (2023). Understanding the Capital Asset Pricing Model (CAPM). https://www.investopedia.com/terms/c/capm.asp
  • U.S. Securities & Exchange Commission. (2022). Flotation Costs and Capital Budgeting. https://www.sec.gov/
  • Frank, M. M., & Goyal, V. K. (2003). Testing the Pecking Order Theory of Capital Structure. Journal of Financial Economics, 67(2), 217-248.
  • Myers, S. C. (1984). The Capital Structure Puzzle. Journal of Finance, 39(3), 575-592.
  • Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
  • Damodaran Online. (2023). Cost of Capital. https://pages.stern.nyu.edu/~adamodar/

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