Question One : LOFTA Corporation is interested in measuring the cost of each specific type of capital as well as the weighted average cost of capital. Historically, the firm has raised capital in the...

Question One :

LOFTA Corporation is interested in measuring the cost of each specific type of capital as well as the weighted average cost of capital. Historically, the firm has raised capital in the following manner:

The tax rate of the firm is currently 30%. The needed financial information and data are as follows:

Debt
LOFTA can raise debt by selling $1,000-par-value, 6.5% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $20 per bond needs to be given. There is an associated flotation cost of 2% of par value.

Preferred stock
Preferred stock can be sold under the following terms: The security has a par value of $100 per share, the annual dividend rate is 6% of the par value, and the flotation cost is expected to be $4 per share. The preferred stock is expected to sell for $102 before cost considerations.

Common stock
The current price of Nova’s common stock is $35 per share.  The cash dividend is expected to be $3.25 per share next year. The firm’s dividends have grown at an annual rate of 5%, and it is expected that the dividend will continue at this rate for the foreseeable future. The flotation  costs are expected to be approximately $2 per share. Nova can sell new common stock under these terms.

Retained earnings
The firm expects to have available $100,000 of retained earnings 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. (Note: When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners.)

TO dO

Create a spreadsheet to answer the following questions:

1. Calculate the after-tax cost of debt.


2. Calculate the cost of preferred stock.


3. Calculate the cost of retained earnings.


4. Calculate the cost of new common stock.


5. Calculate the firm’s weighted average cost of capital using retained earnings and the capital structure weights shown in the table above.


6. Calculate the firm’s weighted average cost of capital using new common stock and the capital structure weights shown in the table above.

Question 2:

Assume that the risk-free rate, RF, is currently 8%, the market return, RM, is 12%, and asset A has a beta, of 1.10. (could be done on word document or excel).

1. Draw the security market line (SML)


2. Use the CAPM to calculate the required return, on asset A.


3. Assume that as a result of recent economic events, inflationary expectations have declined by 3%, lowering RF and RM to 5% and 9%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required return for asset A.


4. Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 2%, to be14%. Ignoring the shift in part c, draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A.


5. From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets?