Common Stock Valuation and Cost of Capital - Case Study Example

Common Stock Valuation and Cost of CapitalPart I: Common Stock ValuationWith supernormal dividends, stock prices are determined when dividends level-off at the prevailing constant growth rate. This is followed by the determining present value of future stock prices. This value is then added to the present value of total dividends earned/paid in the supernormal growth period. After the payment of the third dividend, stock will follow a constant growth path. Therefore, it is recommended that stock prices be determined in the third year because it is this time that constant dividend growth begins (Clayman, Fridson, & Troughton, 2012).

The computation of this procedure is as below: P3 = D3 (1 + g) / (R – g) P3 = D0 (1 + g1)3 (1 + g2) / (R – g) P3 = $1.25(1.15)3(1.06) / (0.11 – 0.06) P3 = $40.30Current price of stock is the present value of the first three dividends added to the present value of stock price of year three. Therefore, current stock price will be: P0 = $1.25(1.15) / 1.11 + $1.25(1.15)2 / 1.112 + $1.25(1.15)3 / 1.113 + $40.30 / 1.113 = $33.50From the above calculations, this stock is selling at $30 that is below $33.

50 based on its predictable future cash flows. Therefore, it is undervalued since its selling price is relatively below the intrinsic value. From investments point of view, the company is priced below its true value. For this reason, it is rewarding investing this company’s shares because its stocks have a high probability of appreciating, hence a good investment opportunity that guarantee capital gains. This strategy (value investing strategy) has worked out well for Marquette Inc. given that its portfolio has consistently outperformed others in the broader market.

Chief Financial Officers whose stocks are undervalued are less likely to issues them because such companies operate below their true value, thus have to pay more dividends in the future (Clayman, et al., 2012).Part II: Cost of CapitalThe first step is computation of cost of debt. Cost of debt represents bond’s yield to maturity. From yield to maturity calculator, this value is 7.51%. Therefore, the after tax cost of debt is equal to 7.51% × (1 – 0.40) = 4.506%Second step involves calculation of the cost of equity.

With information on cost of debt available, it is possible to apply capital asset pricing model (CAPM) to compute the cost of equity. This is arrived at as follows:Cost of Equity = Risk Free rate + (Beta × Market Risk Premium) = 4.50% + (1.20 × 5.50)% = 11.10%.The third and finally step is the determination of Weighted Average Cost of Capital. Using the formula;WACC = (cost/equity * weight of equity) + (cost of debt * weight of debt). Thus, WACC = (0.65 × 11.10) + (0.35 × 4.506) = 8.7921%The company’s return on assets falls short of its WACC.

This is an indication that this company is declining in value. This will scare away potential investors who would preferably invest their resources elsewhere that offer promising returns. Such decline in the value of the firm, therefore, raises concern about the company’s ability to raise capital in the future.ReferenceClayman, M. R., Fridson, M. S., & Troughton, G. H. (2012). Corporate Finance Workbook: A Practical Approach. Hoboken, NJ: Wiley.