Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firm’s last dividend (D0) was $2, and its current stock price is $23. The firm’s beta coefficient is 1.6; the rate of return on 20-year T-bonds currently is 9%; the expected rate of return is 13%. The firm’s target capital structure calls for 50% debt financing, the interest rate required on the business’s new debt is 10%, and its tax rate is 40%.
1. Calculate Medical Associates’ cost of equity estimate using the DCF method.
The company’s current stock price, Po, is $23, and its next expected annul dividend, E(D1), is $2. Thus, the firm’s Discounted Cash Flow (DCF) estimate of R(Re), according to the DCF model is: R(Re) = E(D1)/Po +E(g).
Answer 1 Last dividend 2
Dividend growth rate 7%
Current stock price 23
AS per DDM, Re = D1/P0 + g 16.30%
2. Calculate the cost of equity estimate using the Capital Asset Pricing Model (CAPM).
CAPM is a widely accepted finance model that specifies that equilibrium risk/return relationship on common stocks, it assumes that investors consider only one risk factor when setting required rates of return. Within the CAPM, the actual equation that relates risk to return is the Security Market Line (SML):
R(Re) = RF + [R(Rm) – RF] x b
R(Re) = RF + (RPm x b)
Risk free return 9%
Return from market 13%
As per CAPM,
Cost of equity = Rf+ (Rm – Rf)*β 15.40%
Managers can estimate the required rate of return on the firm’s stock, R(Re), given estimates of the risk-free rate, RF, the beta of the stock, (b) 1.6, and the required rate of return on the market, R(Rm). RM = to the expected market return is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500 Index. For example, over the last 17 years or so, the S&P 500 has yielded investors an average annual return of around 8.10%. This estimate, in turn can be used as the estimate for the Firm’s cost equity.
3. On the basis of your answers to #1 & #2, what is your final estimate for the firm’s cost of equity?
Answer 3 CAPM, is a better measure among CAPM and DDM approach. Cost of equity 15.40%
4. Calculate the firm’s estimate for corporate cost of capital.
Weight Pre tax cost Post tax cost Weight*post tax cost
Debt 50% 10% 6.00% 3.00%
Equity 50% 15.40% 15.40% 7.70%
Cost of capital 10.70%
5. Describe the four (4) steps of capital budgeting analysis.
The four steps to capital budgeting are as follows:
1. Estimation of cash flows; the investment to be made is to be determined. The income from the project either in terms of profits or cash flows is to be estimated.
2. Assessment of riskiness of the cash flows; the riskiness of the project is to be compared to that of the existing projects of the firm.
3. Determining the appropriate discount rate; the discount rate to be used for the project is then determined according to the riskiness of the project and the proportions of various capitals used.
4. Finding the PV of cash flows; the last step is to discount the cash flows with the appropriate discount rate, to compute the present value of expected cash flows.
6. Describe how is project risk is incorporated into a capital budgeting analysis.
The risk involved in a project is reflected in its discount rate. The higher the risk of the project, the higher will be required return of the capital providers. Thus, the discount rate of the project is high. The risk thus reduces the present value of the project.
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