Week 4 Purpose Of Assignment

Week 4purpose Of Assignmentthe Purpose Of This Assignment Is To Allow

The purpose of this assignment is to allow the student an opportunity to calculate the rate of return of equity and debt instruments. It allows the student to understand the effects of dividends; capital gains; inflation rates; and how the nominal rate of return affects valuation and pricing. The assignment also allows the student to apply concepts related to CAPM, WACC, and Flotation Costs to understand the influence of debt and equity on the company's capital structure.

Assignment Steps Resources: Corporate Finance 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:

1. 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.

2. 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?

3. 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?

4. 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)?

5. 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?

Paper For Above instruction

Financial decision-making within corporations hinges on accurately evaluating investment opportunities, understanding the components of return, and optimizing the capital structure to maximize shareholder value. This paper explores key financial concepts including stock valuation, total return, the Capital Asset Pricing Model (CAPM), Weighted Average Cost of Capital (WACC), and Flotation Costs through specific calculations. These concepts inform strategic choices regarding investments, financing, and operational growth for companies.

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

The initial stock price is $100, with a dividend payout of $2.00 during the year, and an ending share price of $125. The total return comprises income from dividends and capital appreciation. The dividend yield is calculated as the dividend divided by the initial price, resulting in 2%, which reflects the income component relative to the purchase price. The capital gains yield is the percentage increase in share price, computed as (125 - 100) / 100 = 25%. The total return combines both components: (Dividend + Capital Gain) / Initial Price, equating to (2 + 25) / 100 = 27%. These metrics reveal that investors earned a 27% total return on the stock during the year, driven primarily by capital gains.

Total Return on Preferred Stock

Buying preferred stock at $100 with a 4% dividend results in an annual dividend income of 4% of $100, which is $4. The stock’s market value increased to $120. The total return considers both the dividend income and the capital appreciation: (Dividend + Capital Gain) / Initial Investment. The capital gain here is $20 ($120 - $100). Therefore, total return is ($4 + $20) / $100 = 24%. This indicates a substantial gain driven by both dividend income and the increase in the market value of the preferred stock, highlighting preferred stocks’ role in income and appreciation potential.

Expected Rate of Return Using CAPM

The CAPM formula is: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate). Substituting the given values, we obtain: 5% + 1.2 × (12% - 5%) = 5% + 1.2 × 7% = 5% + 8.4% = 13.4%. The expected return of 13.4% guides investors in assessing whether a stock’s return compensates for its risk relative to the market, with the beta indicating higher systematic risk compared to the market itself.

Calculating WACC

The WACC formula is: WACC = (E/V) × Re + (D/V) × Rd × (1 - Tax Rate). Here, E/V is 80%, D/V is 20%, Re is 12%, Rd is 7%, and Tax Rate is 30%. Calculations yield: WACC = 0.8 × 12% + 0.2 × 7% × (1 - 0.3) = 0.8 × 12% + 0.2 × 7% × 0.7 = 9.6% + 0.2 × 4.9% = 9.6% + 0.98% = 10.58%. This WACC reflects the average cost to finance the company’s assets, factoring in the proportionate costs of equity and debt adjusted for tax benefits from debt financing.

Initial Cost of Plant with Flotation Costs

Given Medina Corp’s debt-equity ratio of 0.75, the firm’s total capitalization is split into debt and equity. If the firm raises all equity externally to finance a $125 million plant, it must account for flotation costs, which increase the initial amount needed. Flotation costs on equity are 10%, meaning actual proceeds per dollar of equity issued are 90 cents. The initial cost before flotation charges is: Cost / (1 - Flotation Cost) = $125 million / 0.9 ≈ $138.89 million. If the company raises all funds via equity, this amount accounts for flotation costs, making the total initial investment approximately $138.89 million, which is necessary to cover the project costs after raising the funds externally.

Implications of Financial Calculations on Corporate Decision-Making

The calculations demonstrate how companies evaluate investment opportunities and financing decisions. Stock valuation, by decomposing total returns into dividend yield and capital gains, enables investors to assess stock attractiveness relative to alternative investments. The application of CAPM allows managers and investors to estimate expected returns based on systematic risk, guiding portfolio decisions and risk management strategies.

WACC serves as a critical hurdle rate in capital budgeting, influencing the selection of projects and determining the minimum acceptable return on new investments. A lower WACC increases the likelihood of project acceptance, fostering growth and competitive advantage. Flotation costs highlight the importance of financing choices; issuing new equity incurs costs that must be considered in project evaluation to ensure profitability and shareholder value enhancement.

In essence, sound financial decision-making relies on integrating quantitative analyses with strategic considerations. Companies must balance risk and return, optimize their capital structure to minimize costs, and evaluate investments’ net present value to align with long-term goals. These financial concepts underpin the complexity of corporate finance, emphasizing the importance of careful calculations and strategic planning in sustainable business success.

References

• Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2016). Corporate Finance (11th ed.). McGraw-Hill Education.
• Fabozzi, F. J., & Drake, P. P. (2010). The Theory and Practice of Investment Management. John Wiley & Sons.
• Damodaran, A. (2015). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). John Wiley & Sons.
• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
• Sharpe, W. F., & Alexander, G. J. (2012). Investments. Pearson.
• Ross, S. A., & Westerfield, R. W. (2013). Corporate Finance. McGraw-Hill Education.
• O’Neill, H. M. (2018). Capital Budgeting and Investment Analysis. Routledge.
• Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47(1), 13-37.
• Siegel, J. (2014). Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies. McGraw-Hill.