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berry0331
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Joined: 04 Sep 2011
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Posts: 49

Posted: 18 Jan 2012 at 00:53 \| IP Logged

Hi everyone,
I have been studying Becker and I came across several problems that I
don't understand. Can anyone help me out on this?

1. Iota Corporation is using the PEG ratio to forecast its stock price in the
coming year. The company's current price and EPS are $100 and $10
respectively. Growth is expected to be 2.5%. What is the projected stock
price?
a. 41 b. 42 c. 105 d. 108

Explanation
Choice "b" is correct. Projected stock price would be approximately
$42.03, computed as follows:
Choice "a" is incorrect. The proposed answer does not apply a growth
factor to the subsequent year's earnings.
Choice "c" is incorrect. The proposed solution uses the P/E ratio rather
than the PEG ratio.
Choice "d" is incorrect. The proposed solution applies the growth factor to
the P/E ratio and does not use the PEG ratio.

I don't get why B. Can anyone explain this? How can $100 as its current
price be dropped down to 42?

Williams, Inc. is interested in measuring its overall cost of capital and has
gathered the following data. Under the terms described below, the
company can sell unlimited amounts of all instruments.

•     Williams can raise cash by selling $1,000, 8 percent, 20-year bonds
with annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay floatation costs of
$30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.

•     Williams can sell 8 percent preferred stock at par value, $105 per
share. The cost of issuing and selling the preferred stock is expected to
be $5 per share.

•     Williams' common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and floatation costs are expected to amount
to $5 per share.

•     Williams 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.

•     Williams' preferred capital structure is:
Long-term debt     30% Preferred stock     20 Common stock     50
The cost of funds from the sale of common stock for Williams, Inc. is:

a.     7.0 percent. b.     7.6 percent. c.     7.4 percent. d.     7.8 percent.

Explanation

Choice "b" is correct. 7.6%. Williams would receive $92 per share ($100
less $5 flotation cost and $3 underpricing) and pay an annual dividend of
$7/share. The annual cost is:
This question purely asks the cost of new common shares issued. The
problem gives you the expected dividend to be paid annually ($7) and the
net proceeds after issue costs and market adjustments $92 (current
selling price of $100 minus the $3 market adjustment and the $5
floatation costs). The cost of common shares issued is the finance charge
(dividend) divided by the net proceeds of the issue $92 or 7.6%.
Choices "a", "c", and "d" are incorrect, per above.

For this problem, the current price is deducted from flotation cost and
underpricing. However, when I see the same scenario with the different
question which asks to compute WACC, the cost of equity is simply 7%,
deriving from the original $100 base. The additional information for
calculating WACC would be that the company needs $200,000. I know
this piece of information is taken into consideration but I want to know
why. Also, for the real exam, if I see the flotation cost and other
necessary cost associated with equity, do I subtract the costs from the
current price of equity?

Thank you in advance!

ramplacentia
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Joined: 06 Dec 2011
Location: United States
Online Status: Offline
Posts: 37

Posted: 20 Jan 2012 at 22:08 \| IP Logged

Dear Friend,
read the last line of the question.
The cost of funds from the sale of common stock for Williams, Inc. is:

The cost of funds from the sale of common stock that is the catch compared to the other question you referred. If it is cost of retained earnings then the answer would be 7%.
I too got confused initially - but read the last line of the question one more time.
Thanks

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BEC

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