Rate of Return for Stocks and Bonds

Rate of Return for Stocks and Bonds

FIN/571

Rate of Return for Stocks and Bonds

Introduction

In this week’s assignment, I had the opportunity to calculate the rate of return of equity and debt. Understanding these calculations will provide and understanding of the effects of dividends, capital gain, inflation rates and how the nominal rate of return affects valuation and pricing. Capital Asset Pricing Model (CAPM), Weighted Average Cost of Capital (WACC) and flotation cost will be applied for the requested calculations. Being able to understand these calculations will provide a basic understanding of the calculations used to make important financial decisions.

Stock Valuation

The stock valuation method calculates stock to values. Proper execution of this method allows companies to make business decision concerning future stock market prices. Stock Valuation methods have two categories: relative and absolute. Absolute valuation models attempt to find the intrinsic or true value of an investment based only on fundamentals. Relative valuation is when the value of an asset is determined by comparing it to a similar asset.

The Return of Stock is R= [(125-100) +2.00]/100= 0.27 or 27%

• Stock Valuation: A stock has an initial price of $100 per share, paid a dividend of $2.00 per share during the year, and had an ending share price of $125. Compute the percentage total return, capital gains yield, and dividend yield. (Ross, Westerfield, Jaffe, & Jordan, 2016)

The Capital Gains yield= (125-100)/100= 0.25 or 25%

The Dividend yield= 2.00/100= 0.02 or 2%

Total Rate of Return

Total Rate of Return is the rate of return is the gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s cost. Organizations use total rate of return to make investment decisions. It is calculated when the capital gain interest and cost of investment over a specified period of time are added together then divided by the cost of investment. (Ross, Westerfield, Jaffe, & Jordan, 2016)

2.Total Return: You bought a share of 4% preferred stock for $100 last year. The market price for your stock is now $120. What was your total return for last year?
(120-100+4.00)/100= 0.24 or 24%

Capital Asset Pricing Model

Capital asset pricing model (CAPM) An equilibrium asset pricing theory that shows that the equilibrium expected return on all risky assets is a function of their covariance with the market portfolio (Ross, Westerfield, Jaffe, & Jordan, 2016). It is used with compensation has to be paid out by the time value of money and the risk. It allows for investing over a designated time period, while calculating potential risk involved with the investment.

3.CAPM: A stock has a beta of 1.20, the expected market rate of return is 12%, and a risk-free rate of 5 percent. What is the expected rate of return of the stock?
1.20(12.00-5.00) +5.00=13.40%

Weighted Actual Cost of Credit

Weighted Actual Cost of Credit (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. Organizations use WACC to evaluate the value of an investment to determine if the company should move forward with the investment or sell it off. If the WACC is low, the organization’s revenue is decreasing. If it is high the company is earning money off each investment.

4.WACC: The Corporation has a targeted capital structure of 80% common stock and 20% debt. The cost of equity is 12% and the cost of debt is 7%. The tax rate is 30%. What is the company’s weighted average cost of capital (WACC)?

WACC- (80/100 x.12) + (20/100 x 0.07) (1-.30)

(0.8 x .12) + (0.2 x 0.07) (1-.30)

0.096 + 0.014(1-.30)

0.11 (0.7) = 0.077

0.077 x100= 7.7%

Flotation Cost

Flotation cost is the cost accrued from expenses such as underwriting, registration and legal. Floatation costs is costs firms incur when issuing new securities. Flotation cost affect possible capital such as loans and equity bonds. (Ross, Westerfield, Jaffe, & Jordan, 2016).

Flotation Cost- 125 million= (1-.10) x amount raised

• Flotation Costs: Medina Corp. has a debt-equity ratio of .75. The company is considering a new plant that will cost $125 million to build. When the company issues new equity, it incurs a flotation cost of 10%. The flotation cost on new debt is 4%. What is the initial cost of the plant if the company raises all equity externally?

125M/.90= 138.88 million

References

Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate Finance (11th). New York, NY: McGraw-Hill.