Question

The Triple Seven Systems, Inc. (TSS), is starting its planning process for next year. Jack Tripper, the firm's CFO, calculates the weighted cost of capital each year to be used as a discount rate in the NPV analysis. You have been asked to help Mr. Tipper to compute the firm's cost of capital. You have collected the following data to do the job: a. TSS bonds carry a coupon rate of 6% with semi-annual payments, a $1,000 par, a AAA rating, and a maturity of 10 years. The current price of the TSS bonds is $950. TSS preferred stock currently pays a 10% dividend rate on a $100 par value and has a market value of $95 per share. TSS common shares paid a dividend of $5 last year. Dividends have grown at a rate of 6% per year and are expected to continue for a foreseeable future. The market price of the stock is $55 and there would be a flotation cost of 5% on a new issue. TSS' capital structure is as follows: Bonds (2,000 bonds outstanding) 2,000,000 Preferred stock (10,000 shares outstanding) 1,000,000 Common stock (600,000 shares) 6,000,000 The firm's average tax rate is 35% and its marginal tax rate is 40%. TSS uses five companies for peer-group comparisons. These five firms along with their betas after being adjusted for financial leverage effects are as follows: Peer Group Firms Beta Western Pacific 1.30 Telectroics, Inc. 1.33 Pacific United 1.28 Peer Group Firms Southwestern, Inc. Ecological System, Inc Beta 1.26 1.18 Treasury bond currently yields 3% (TRF) and the expected market return (I'm) is 10%.

Using the information above answer the following. What is the cost of retained earnings, first based on the DCF approach and then based on the CAPM approach using an average beta of peer groups as TSS' beta. Calculate the average of the two approaches. Please use excel and show the steps. Thank you.

Answer 1

Cost of retained earnings (DCF) 01:PO+g| Here, 55 Net stock price (PO) Expected dividend (D1) Growth rate (g) 5.30 =5*(1+6%) 6% Cost of retained earnings (DCF) 15.64% 5.3:55+6%

Cost of retained earnings (CAPM Rf+BxRp Here, Risk free rate of return (RF) Beta of the stock (B) Market risk premium (Rp) 3% 1.27 =(1.3+1.33+1.28+1.26+1.18)/5 7% =10%-3% Cost of retained earnings (CAPM) 11.89% 3%+1.27x7%

Cost of retained earnings(DCF) Cost of retained earnings(CAPM) 15.64% 11.89% Average cost of retained earnings 13.77% (15.64%+11.89%)/2

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