1. Amgel Manufacturing Company’s current capital structure is compromised of 30% debt and 70% equity (based on market values). Amgel’s equity beta (based on its current level of debt financing) is 1.20, and its debt beta is 0.29. Also, the risk free rate of interest is currently 4.5% on long term government bonds. Amgel’s investment banker advised the firm that, according to its estimated, the market risk premium is 5.25%.
A. What is your estimate of the cost of equity capital for Amgel (based on the CAPM)?
B. If Amgel’s marginal tax rate is 35%, what is the firm’s overall weighted average cost of capital (WACC)?
C. Amgel is considering a major expansion of its current business operations. The firm’s investment banker estimates that Amgel will be able to borrow up to 40% of the needed funds and maintain its current credit rating and borrowing cost. Estimate the WACC for this project.
2. Intel corporation is a leading manufacturer of semiconductor chips. The firm was incorporated in 1968 in Santa Clara, California and represents one of the greatest success stories of the computer age. Although Intel continues to grow, the industry in which it operates has matured so there is some question whether the firm should be evaluated as a high-growth company or stable growth company from now on. For example, in December of 2007, the firm’s shares were trading for $20.88, which represented the price earnings ratio of only 17.61. Compared to Google, Inc.’s price earnings ratio of 53.71 on the same date, it would appear that the decision has already been made by the market. Intel’s expected earnings for 2007 are $1.13 per share, and its payout ratio is 48%.
A. Is Intel’s current stock price of $20.88 reasonable in light of its sector, industry and comparison firms?
B. Intel has a beta coefficient equal to 1.66. If we assume a risk free rate of 5.02% and a market risk premium of 5%, what is your estimate of the required rate of return for Intel’s stock using the CAPM? What rate of growth in earnings is consistent with Intel’s policy of paying out 40% of earnings in dividends and the firm’s historical return on equity? Using your estimated growth rate, what is the value of Intel’s shares using the Gordon (single-stage) growth model? Analyze the reasonableness of your estimated value per share using the Gordon model.
C. Using your analysis in part b above, what growth rate is consistent with Intel’s current share price of $20.88.
D. Analysts expect Intel’s earnings to grow at a rate of 12% per year over the next five years. What rate of growth from Year 6 forward (forever) is needed to warrant Intel’s current stock price (use your CAPM estimate of the required rate of return on equity)? (Hint: Use a two stage growth model where Intel’s earnings grow five years at 12% and from year 6 forward at a constant rate).