Question 1: The Shrieve Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7.5%, state of Florida muni bonds, which yield 5%, and AT&T preferred stock, with a dividend yield of 6%. Shrieve's corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax returns on both securities.
Question 2: You buy a share of The Ludwig Corporation stock for $21.40. You expect it to pay dividends of $1.07, $1.1449, and $1.2250 in Years 1, 2, and 3, respectively, and you expect to sell it at a price of $26.22 at the end of 3 years.
a) Calculate the growth rate in dividends.
b) Calculate the expected dividend yield.
c) Assuming the calculated growth rate is expected to continue, you can add the dividend yield to the expected growth rate to get the expected total rate of return. What is the stock's expected total rate of return?
Question 3: On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.
Debt: $30,000,000
Common equity: $30,000,000
Total capital: $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. Stockholders' required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 = 4%.) The marginal corporate tax rate is 40%.
a) To maintain the present capital structure, how much of the new investment must be financed by common equity?
b) Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity. What is the WACC?
c) Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?