Reference no: EM13356597

Recalculating cost of equity - WACC.

1. Ecology Labs, Inc., will pay a dividend of $3 per share in the next 12 months (D1). The required rate of return (Ke) is 10 percent and the constant growth rate is 5 percent.
a. Compute P0.
(For parts b, c, d in this problem, all variables remain the same except the one specifically changed. Each question is independent of the others.)
b. Assume Ke, the required rate of return, goes up to 12 percent; what will be the new value of P0?
c. Assume the growth rate (g) goes up to 7 percent; what will be the new value of P0? Ke goes back to its original value of 10 percent.
d. Assume D1 is $3.50; what will be the new value of P0? Assume Ke is at its original value of 10 percent and g goes back to its original value of 5 percent.

2. United Business Forms' capital structure is as follows:

Debt	35%
Preferred stock	15
Common equity	50

The after tax cost of debt is 7 percent, the cost of preferred stock is 10 percent, and the cost of common equity (in the form of retained earinings) is 13 percent. 

Calculate United Business forms' weighted average cost of capital in a manner similar to Table 11 - 1 on page 328.

3. As an alternative to the capital structure shown in Problem 17 for United Business Forms, an outside consultant has suggested the following modifications.

Debt	65%
Preferred stock	5
Common equity	30

Under this new, more debt-oriented arrangement, the after tax cost of debt is 9.8 percent; the cost of preferred stock is 12 percent; and the cost of common equity (in the form of retained earnings) is 15.5 percent.

Recalculate United Business Forms' weighted average cost of capital. Which plan is optimal in terms of minimizing the weighted average cost of capital?