Strategic

MANG2015

Financial Management

Class for Lectures 8 &9

Cost of Capital and Capital Structure

Agency Problems, Compensation and Performance Measurement

Payout Policy

Dr Fotios Papadimitriou

Question 1

GBK Inc. has 40% debt and 60% equity in its capital structure. Cost of debt (before tax) is 11%. Currently, GBK stock is selling at a price of $40 and is about to pay a dividend of $3. Dividends are expected to grow at a constant rate of 8%. Calculate the cost of equity and the tax-adjusted weighted average cost of capital (WACC). Assume a tax rate of 36%.

Question 2

BP has 4.6 million shares outstanding, now trading at $32 per share, and its total debt value is $18 million. The company pays tax at a marginal rate of 28%. Moreover, it has issued long-term bonds at an interest rate of 6%. Finally, BP has an asset beta of 1.2 while the risk-free interest rate is 4% and the return on the market is 8%. What is BP’s after-tax weighted average cost of capital (WACC)?

Question 3

Union Pacific earned $1.6 million on net assets of $20 million. The cost of capital is 11.5%. Calculate the net return on investment (ROI) and the economic value added (EVA).

Question 4

Management compensation must in practice rely on results rather than on effort. Why? What problems are introduced by not rewarding effort?

Question 5

a) James owns 1,000 shares of a firm that has just announced an increase in its dividend from $2.00 to $2.50 a share. The share price is currently $150. If James does not wish to spend the extra cash, what should he do to offset the dividend increase?

b) Jenny owns 1,000 shares of a firm that has just announced a decrease in its dividend from $8.00 to $5.00 a share. If Jenny wishes to maintain her consumption, what should she do to offset the dividend cut?

Question 6

Shares A and B both sell for £100 and offer a pretax return of 10%. However, in the case of company A the return is entirely in the form of...