Corporate Finance, Reading 27:- Corporate Governance. Practice problem 25)

[300hoursoverand]

How is the value of Re determined as 9. I use the formula Re=Rwacc+(Rwacc-Rd)(1-t) D/E but i get the answer as 9.322. Could some one explain the logic behind the 9 value for Re which is later used in the P/E multiple calculation? Also, could u mention what values u used for D/E? The question doesnt not specify the amount of Net Income so I am not sure of what to subtract from E. However, it says that 50% of NI is paid out as dividends.

 

[JayWill]

You may be overthinking the problem or misread the vignette. All the information is given.
1) Note: Current capital structure (indicated in italics) is $2 billion of debt, $8 billion of equity.
The line in italics in Exhibit 1 lists the current cost of equity (re) as 10%
2) “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.”
New cost of equity after dividend initiation = 10% - 100bps = 9%
“Lee also thinks that distributing an amount equal to half of its net income as a dividend may change Skylark’s leading P/E.”
Distributing half of NI means the payout ratio = (1-b) = 50%
Leading P/E = (1-b)/(r-g) ; .50/.09-.07 = 25