Resources: Rate Of Return For Stocks And Bonds Grading Guide

Resourcesrate Of Return For Stocks And Bonds Grading Guidecorporate Fi

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: 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. 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? 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? 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)? Flotation Costs: Medina Corp. has a debt-equity ratio of .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%. The flotation cost on new debt is 4%. What is the initial cost of the plant if the company raises all equity externally? Submit your summary and all calculations.

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The process of making informed financial decisions is fundamental to corporate success, involving meticulous analysis of various components like stock returns, risk assessments, capital costs, and flotation expenses. These calculations are essential for understanding investment profitability, risk management, and optimal capital structure strategies. Each element, from stock valuation to assessing the effects of flotation costs, provides insights into how firms evaluate and execute investment opportunities, ultimately influencing their valuation and financial stability.

Firstly, stock valuation involves calculating the total return, dividend yield, and capital gains yield, which are crucial for investors assessing the attractiveness of a stock. In the given scenario, a stock initially priced at $100, paying a dividend of $2, and ending at $125, illustrates how dividend income and price appreciation contribute to overall returns. The total return combines income from dividends and capital gains, giving investors insight into overall profitability. The dividend yield is the dividend relative to the initial price, and the capital gains yield is the appreciation in stock price over the period.

Specifically, the total return is computed as the sum of the dividend yield and capital gains yield. The dividend yield is calculated as the dividend divided by the initial share price, and the capital gains yield is the percentage increase in share price. In this example, the dividend yield is ($2 / $100) = 2%. The capital gains yield is (($125 - $100) / $100) = 25%. The total return, therefore, is 2% + 25% = 27%. This figure demonstrates how growth in stock price combined with dividends enhances investor returns.

Secondly, the total return on preferred stock provides an understanding of fixed income investments. Purchased at $100 with a 4% dividend rate, the preferred stock pays $4 annually. When the market price increases to $120, the total return incorporates both dividend income and capital appreciation. The return from dividends is $4, and the appreciation in stock price ($120 - $100) is $20. The total return percentage is ($4 + $20) / $100 = 24%. This outcome highlights the significance of both stable dividend income and capital gains in preferred stock investments.

The Capital Asset Pricing Model (CAPM) helps estimate expected returns by considering risk factors inherent in stocks. With a beta of 1.20, the expected market return of 12%, and a risk-free rate of 5%, the expected return is calculated as: Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate). Substituting values, Expected Return = 5% + 1.20 × (12% − 5%) = 5% + 1.20 × 7% = 5% + 8.4% = 13.4%. This expected return reflects the risk premium characteristic of the stock relative to the market.

The Weighted Average Cost of Capital (WACC) determines a firm’s overall cost of financing, considering the proportion of debt and equity in its capital structure. In this case, with 80% equity at 12% cost and 20% debt at 7%, and a tax rate of 30%, the WACC is computed as: WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc). Therefore, WACC = 0.8 × 12% + 0.2 × 7% × (1 − 0.3) = 0.8 × 12% + 0.2 × 7% × 0.7 = 9.6% + 0.98% = 10.58%. This rate guides the company in evaluating projects and investments, ensuring they generate returns exceeding this cost.

Lastly, flotation costs impact the actual capital needed to finance a new project. Medina Corp. plans to build a $125 million plant and raises capital externally. With flotation costs of 10% for equity and 4% for debt, and a debt-equity ratio of 0.75, the initial cost calculation involves adjusting the project cost to account for these expenses. When raising all equity, the total amount needed before flotation costs is calculated by dividing the project cost by 1 minus the flotation cost rate: $125 million / (1 − 0.10) = approximately $138.89 million. This figure underscores the importance of factoring in flotation costs to accurately determine the total capital required for project funding.

In summary, these financial calculations illustrate the complexities involved in corporate investment decision-making. Stock return analysis demonstrates the importance of dividend income and capital appreciation in shareholder wealth. Understanding CAPM helps in assessing the risk-adjusted expected return of stocks, guiding investment and financing choices. WACC provides a comprehensive measure of the firm’s cost of capital, critical for evaluating project viability. Flotation costs reveal the additional expenses incurred during capital raising, influencing the total funding requirements. Together, these tools enable firms to optimize their capital structure, enhance shareholder value, and support sustainable growth within the constraints of market and economic conditions.

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