Hi guys, how’s everyone doing? Was wondering if there’s anything wrong with the answers provided? Cost of equity in the table clearly states 9.7% for 10/90 Debt/Equity. But in the answer it’s 9%. Am I missing something here?
Exhibit 1. Skylark Industries Estimated Costs of Capital for Various Capital Structures
Weight of Debt at** Market Value (%) Weight of Equity at Market Value (%) Pretax Cost of Debt (%) Cost of Equity (%) Weighted Average Cost of Capital (%)** 10 90 5.3 9.7 — 20 80 5.5__10.0 — 30 70 6.0 10.5 — 40 60 6.7 11.2 8.44 50 50 7.5 12.0 8.40 60 40 8.6 13.2 8.58 70 30 10.0 15.0 8.98
Note: Current capital structure (indicated in italics) is $2 billion of debt, $8 billion of equity.
Given Skylark’s current capital structure and Miller’s assumption about the dividend’s effect on the cost of equity, initiating a dividend will result in a price-to-earnings multiple closest to:
- 16.7.
- 20.0.
- 25.0
C is correct. The Gordon growth model can be used to calculate the P/E as the payout ratio divided by the difference between cost of equity and growth. In this case, the payout ratio would be 50%, cost of equity would drop from the current 10% (see table) to 9%, and the growth rate is 7%. The leading P/E is 0.5/(0.09 – 0.07) = 25×.
Hey Sean,
So you might wanna be a bit careful while reading the question. The question says 2bn debt and 8bn equity and the table has given debt and equity as a % of total capital. In short, use debt to capital here and not debt to equity.
Hey,
Thanks for the prompt reply! But still quite confused. Anyhow took your advice and read the question once more and I noticed that they probably just assumed that the cost of equity dropped by 100 basis points instead of asking us to prove it.
Lee also thinks that distributing an amount equal to half of its net income as a dividend may change Skylark’s leading P/E. Miller responds, “ Skylark’s competitors that pay a dividend appear to benefit from a 100 basis point reduction in cost of equity, regardless of capital structure. I assume Skylark’s cost of equity would decline by the same amount if it initiates a dividend.” Lee estimates that Skylark’s long-term earnings and dividend growth rate is 7.0 percent.
Maybe that’s how to derive the r = 9% from 10%.
Thanks again!
No! Lets walk through this:
20bn debt + 80bn equity = 100bn total capital, which is 20% debt and 80% equity.
Next, lets look at the table and look for “WEIGHT OF DEBT AND EQUITY” corresponding to the current capital structure.
Since its asking for P/E ratio, lets focus only at the cost of equity, which in this case is 10% based upon the current capital structure.
This cost of equity will fall to 9%, assuming a 50% NI is paid out as dividends. Lets assume the firm does say $10 in EPS out of which $5 is paid out aas divs.
Lets plug in the P/E formula Div payout ratio/k-g = 0.5/0.09-0.07 = 25x.
Hope this helps.