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AUA Financing Costs and Investment Analysis

The document discusses calculating individual costs of different sources of financing for a company including debt, preferred stock, and common stock. It also discusses calculating the company's weighted average cost of capital (WACC) based on target capital structure proportions. Several potential investment opportunities are presented and the document asks which, if any, the company should invest in based on expected rates of return and financing required. It also covers calculating required return on an investment using the capital asset pricing model (CAPM) based on the investment's beta and current market conditions.

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Ani Khachatryan
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9 views2 pages

AUA Financing Costs and Investment Analysis

The document discusses calculating individual costs of different sources of financing for a company including debt, preferred stock, and common stock. It also discusses calculating the company's weighted average cost of capital (WACC) based on target capital structure proportions. Several potential investment opportunities are presented and the document asks which, if any, the company should invest in based on expected rates of return and financing required. It also covers calculating required return on an investment using the capital asset pricing model (CAPM) based on the investment's beta and current market conditions.

Uploaded by

Ani Khachatryan
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

1.

Individual costs and WACC of AUA is interested in measuring its overall cost of capital. The firm is in the
40% tax bracket. Current investigation has gathered the following data:

Debt: The firm can raise debt by selling $1,000-par-value, 10% coupon interest rate, 10-year bonds on
which annual interest payments will be made. To sell the issue, an average discount of $30 per bond
must be given. The firm must also pay flotation costs of $20 per bond.

Preferred stock: The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value.
The cost of issuing and selling the preferred stock is expected to be $4 per share.

Common stock: The firm’s common stock is currently selling for $80 per share. The firm expects to pay
cash dividends of $6 per share next year. The firm’s dividends have been growing at an annual rate of
6%, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per
share, and flotation costs are expected to amount to $4 per share.

Retained earnings: The firm expects to have $225,000 of retained earnings available in the coming year.
Once these retained earnings are exhausted, the firm will use new common stock as the form of
common stock equity financing.

a. Calculate the individual cost of each source of financing. (Round to the nearest 0.1%.)

b. Calculate the firm’s weighted average cost of capital using the weights shown in the following table,
which are based on the firm’s target capital structure proportions. (Round to the nearest 0.1%.)

weight of debt 20.0%


weight of
common 70.0%
weight of
preferred 10.0%

c. In which, if any, of the investments shown in the following table do you recommend that the firm
invest? Explain your answer. How much new financing is required?

initial
investment opportunity expected rate of return investment

1 17.0% 100,000

2 15.0% 50,000

3 13.0% 70,000

4 17.50% 200,000

5 18.8% 30,000

6 16% 40,000

1
1.2

Beta and CAPM Currently under consideration is an investment with a beta, of 1.3. At this time, the risk-
free rate of return, RF, is 3%, and the return on the market portfolio of assets, rm, is 11%. You believe
that this investment will earn an annual rate of return of 11%.

a. If the return on the market portfolio were to increase by 10%, what would you expect to happen to
the investment’s return? What if the market return were to decline by 10%?

b. Use the capital asset pricing model (CAPM) to find the required return on this investment.

c. On the basis of your calculation in part b, would you recommend this investment? Why or why not?

d. Assume that as a result of investors becoming less risk averse, the market return drops by 3% to 8%.
What effect would this change have on your responses in parts b and c?

1.3

1.4

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