Based the data in Table 1, what is a reasonable range for the PNC's cost of common equity based on the own-bond-rate-plus-risk-premium approach? What are some ways this risk premium can be estimated? Also, discuss the pros and cons of this method. Table 1 below:
Table 1. Data Used in the Analysis
Bond Data. Two dollar-denominated bonds are currently outstanding. Bond A has a 6.75 percent semiannual coupon, sells for 88.75 percent of par, matures on July 1, 2029, and can be called at a price of 105 on July 1, 2009. Bond B has a 9.0 percent semiannual coupon, sells for 112.25 percent of par, also matures on July 1, 2029, and can be called at a price of
107.50 on July 1, 2009. PNC's federal-plus-state tax rate is 40 percent. Assume that the analysis is conducted on September 15, 2004, and use this as the settlement date, i.e., the day the bond will be purchased. New bonds carrying the prevailing rate could be sold to institutional investors, and no bond flotation cost would be involved.
Preferred Stock Data. PNC has one issue of preferred stock outstanding, a perpetual and non-callable preferred that pays a $6.25 annual dividend, has a $100 par value, and currently sells for $104 per share. Investment bankers have indicated that PNC could sell additional shares with a dividend rate that would provide the same market yield, but would incur a flotation cost of 2%. Also, it could sell at par an issue of sinking fund preferred with an annual coupon of 5.25%. The sinking fund would require the company to retire 10% of the original shares each year after issuance, and it too would have a 2 percent flotation cost.
c.Common Equity Cost Data
< >. The own-bond subjective risk premium is assumed to be in the range of 3% to 5%.
< >. PNC's estimated beta coefficient is 1.35, with a reasonable range of 1.15 to1.55. The risk-free rate is 4.8%, and the market risk premium (RPM) is estimated to be 5.0%, with a range of 4.0% to 6.0%.
< >. PNC's stock sells for $21 per share. The company currently does not pay a dividend, but its long-run business plan calls for a dividend of $0.50 per share to paid at the end of 2007. The plan also forecasts a growth rate of 75% in 2008, 40% in 2009, and 7.5% thereafter. These specific growth rates have not been reported to the public, but information that has been released provides guidance that has lead analysts to similar but not exact forecasts.< >