Company DD gives you the following information for its operation. The dividends is $8.40/per share before the firm has any debts. Suppose there is a 25% corporate income tax imposed on the company. Company DD has no debt originally. There are 6 million shares of common stocks outstanding. Let the market price for the stock be $48.2 per share before debt. Suppose that there is no expansion plan for the company to either spend on working capital vs. long-term investment or to apply the accumulated retained earnings. Answer the following questions:
a) What is the cost of equity for Company DD’s common stock before debt? Suppose that Company DD now has issued some bonds with 4% coupon rate recently. Let Company DD’s total debts (with the above coupon bond) be $84 million and let this coupon rate represent the cost of debt, how much will be the value of stockholders’ equities under Modigliani and Miller’s proposition 2?
b) What is the cost of equity for Company DD, if there’s no preferred stock issued for this company?
c) What is the weighted average cost of capital after Company DD has debts?
d) Suppose the risk-free rate is 2%, S&P 500 index return is 12%, what is the “beta” of Company DD’s common stock after issuing debts?
e) Explain the M&M proposition 2 in words and intuition. Do not copy the equations given in the class. What are the limitations of M&M proposition 2?