Rate of Return for Stocks and BondsFIN571Running he.docx

Rate of Return for Stocks and Bonds
FIN/571
Running head: RATE OF RETURN FOR STOCKS AND
BONDS
1
RATE OF RETURN FOR STOCKS AND BONDS
2
Rate of Return for Stocks and Bonds
This paper will discuss how capital asset pricing model
(CAPM), weighted average capital cost (WACC) and flotation
costs influence the financial decision making with the capital
budgeting process. Through these calculations, a company can
better understand how the impact of debt and equity has on their
capital structure. These concepts will also allow financial
managers within an organization to make sound investment
decisions when determining whether or not to invest in a
particular project during the capital budgeting process. As a
part of this assignment, calculations of the problems involving
stock valuation, total return, CAPM, WACC, and flotation costs
listed in a separate document under "Calculations – Rate of
Returns for Stocks and Bonds."
Capital Asset Pricing Model (CAPM)
CAPM typically measures the association between the risk
and expected return of a stock portfolio. In this paper, we will

discuss how CAPM is used to estimate the cost of equity capital
and the expected rate of return. There is a particular type of
symmetry when we are looking at the cost of capital to a
company compared to the expected return on a stock.
Companies may use this measure in determining how much
equity they will use to fund a capital budget project. In the
calculation assignment, we calculate the expected rate of return
through CAPM. The expected rate of return equals the risk-free
rate plus the beta times the difference of the expected market
rate and the risk-free rate. We can also use the formula to
estimate the cost of equity. The cost of equity can then be used
to the beta risk of the project and what the discount rate on the
cash flow of the project show be.
Weighted Average Capital Cost (WACC)
"The weighted average cost of capital (WACC) is the rate
of return that the providers of a company's capital require,
weighted according to the proportion each element bears to the
total pool of capital." (Qatar Financial Center, 2014) It
provides a measure similar to the CAPM, which the correct
discount rate on cash flow and it also provides the rate of
interest of capital. Many financial managers used this measure
to make investment decisions while finding the correct capital
structure for their company. In the WACC portion of the
calculation assignment, we were asked to find the WACC which
is the weight of equity within the capital structure multiply by
the cost of equity times the inverse of the tax rate plus the
weight of debt within the capital structure multiply by the cost
of debt. By determining WACC, financial managers can
analyze the value the project. The expected rate of return of
WACC can be used to determine the risk and the capital
structure of the company’s existing assets. This expected rate
of return can then be used to calculate NPV to either accept or
reject a project.
Flotation Costs
“Flotation costs are the costs of issuing debt and equity
security.” (Tegarden, 2008, p71) Flotation costs can be

calculated by reducing the cash flow to discount or including
this value when calculating the WACC or discount rate. Often,
flotation costs are not accounted for, therefore, affecting the
accuracy when calculation for the NPV. Flotation costs are
fixed costs usually around 1 to 2 percent of the debt and around
2 to 6 percent of equity, but it can higher, depending on the size
and type of industry. In the flotation costs example in
calculation assignment, we discussed how flotation cost could
play a part in determining the initial cost of building a plant.
Ultimately, we need to recognize flotation costs and make an
adjustment to the WACC to assist in the decision making of the
capital budgeting process.
Conclusion
In conclusion, we have discussed how the concepts of CAPM,
WACC and flotation costs influence the financial decision
making with the capital budgeting process. A company can
determine how the effect of debt and equity has on their capital
structure by using WACC and adjusting for flotation costs.
These measures will also allow financial managers within an
organization to make intelligent investment decisions when it
comes to capital budgeting.

References
Qatar Financial Center (2014). "Weighted average cost of
capital," QFinance: The Ultimate
Resource. Retrieved from:
http://search.credoreference.com.contentproxy.phoenix.edu/cont
ent/entry/qfinance/weighted_average_cost_of_capital/0?searchI
d=afd14799-94ad-11e6-9610-0a80f32943a1&result=0
Tegarden, T.K. (2008). “The Appraisal of Public Utilities:
Adjustment to the WACC for
Flotation Costs”, Journal of Property Tax Assessment &
Administration. Vol. 5, Issue 1,
p. 71.
C7-1
CASE STUDY 7
DATA CENTER CONSOLIDATION AT GUARDIAN
LIFE
As one of the largest mutual life insurance firms in the United
States,
Guardian Life (www.guardianlife.com) has more than 5000
employees and
over 3000 financial representatives in 80 agencies. Guardian
and its
subsidiaries provide almost three million people with life and
disability

income insurance, retirement services, and investment products
such as
mutual funds, securities, variable life insurance, and variable
annuities. The
company also supplies employee benefits programs to six
million
participants, including life, health, and dental insurance, as well
as qualified
pension plans. In addition to regional home offices in New York
City;
Bethlehem, Pennsylvania; Spokane, Washington; and Appleton,
Wisconsin,
the company has 55 remote sales offices and 80 remote agency
offices.
Like other insurance companies, Guardian Life is an
information
intensive organization where data processing and
communications network
infrastructure have consistently been important contributors to
its success.
Guardian Life’s IT organization has earned numerous accolades
including
multiple CIO100 awards from CIO magazine [PRNE11].
According to Dennis

Callahan, Executive Vice President and Chief Information
Officer for,
Guardian Life, "A strong partnership between IT and the
businesses enables
http://www.guardianlife.com/
C7-2
Guardian to deliver cost-effective technology services that
facilitate world-
class customer service, product innovation, and operational
efficiency.”
Ensuring alignment between business and IT is important to
Guardian Life
and provides a consistent theme for many of the insurance
companies IT
projects including its data center consolidation initiatives
[CIOZ12].
Data center consolidation has been an ongoing concern at
Guardian for
more than a decade. Guardian’s IT governance structure is
team-oriented
and the company’s data center consolidation initiatives are
overseen by it

Infrastructure team. The Infrastructure team is primarily co-
located in New
York, and Bethlehem, Pennsylvania but it has key support teams
in Spokane,
Washington, Appleton, Wisconsin, and Pittsfield,
Massachusetts.
Guardian Life began taking a serious look at data center
consolidation in
2000, but in the aftermath of the September 11, 2001 terrorist
attack,
Guardian also became more concerned with business continuity
issues.
Guardian had four significant data centers, at its four home
offices, but the
primary data center was in New York City. After 9/11, Guardian
wanted
make infrastructure changes to ensure business continuity
across its existing
data centers and made plans to add two more data centers to the
mix.
Guardian performed an assessment of its data centers to
provide a basis
for planning on the location of data processing resources. One
surprising

outcome of this assessment had to do with utilization. The
assessment
revealed that the four data centers had about 1000 UNIX and
NT servers,
with an average capacity utilization of 10%. Even at peak
demand, only 25%
of the processing power of the servers was being used
[MUSI02]. Guardian
responded to this assessment with a plan that included the
following
objectives:
1. Move the primary data center from New York City to
Bethlehem,
Pennsylvania.
C7-3
2. Improve the efficiency of its data centers, including server
and storage
utilization. Specifically, Guardian set a goal of reducing the
number of
servers supporting Guardian's applications and databases by
40% and
reducing the server support staff by 60%.

3. Ensure a smooth transition to the new primary data center.
The company chose IT consulting firm Greenwich Technology
Partners
(GTP) to help it design and carry out the transition. GTP began
with an
assessment of the company's IT environment and looked at the
impact of
moving the data center from New York to Bethlehem. A major
issue related
to the move was that the largest number of data center users was
located in
the New York area. Thus, the new deployment needed to
provide sufficient
data transmission capacity to meet these users' needs.
Fortunately, the
network infrastructure already in place was fairly standard and
easily
scalable (Figure C7.1).
C7-4

An ATM WAN backbone linked the four regional home offices.
Frame
relay connections linked the remote sales offices and remote
agency offices,
and 100-Mbps and 1-Gbps Ethernet LANs provided connectivity
within
campuses. The Cisco Catalyst 5500 and 7200 series routers
provided
Ethernet support combined with a modular, easily scalable
design. The Cisco
IGX 8400 ATM switches could be scaled to support an ATM
network service
at any desired capacity. With three widely used networking
technologies in
place, some of the problems that might have been encountered
in a more
convoluted networking environment were avoided.
GTP also looked at the application and database patterns. They
determined that in addition to traditional applications such as
file and print
services, PeopleSoft, and Lotus Notes, Guardian also used a
collection of
applications to support its intranet. Then, as now, the site
included

marketing materials and sales tools for the firm's agents,
account profiling,
and customer data. The company had also invested in a number
of financial
services applications, including applications for supporting its
trading and
securities functions. Due to their complexity and the amount of
resource
required to support them, many of Guardian's applications have
historically
been supported by dedicated servers.
The transition team, consisting of Guardian and GTP
personnel, did
extensive validation work and benchmarking to make sure the
data they had
gathered during the initial assessment were accurate. They
measured
network utilization at granular levels and modeled various
consolidation
scenarios for reducing server hardware.
From this analysis, GTP proceeded to develop a plan for
consolidating
the servers, looking at both business and technology issues. For

example,
the team considered the criticality of the applications supported
by the
servers, as well as which business units they belonged to. Some
servers
were good candidates for consolidation; others were not; and
others were
out of warranty, which made them too expensive to keep. After
the
C7-5
migration plan was devised and the new architecture developed,
more
testing was conducted to ensure their viability.
The team devoted much thought and analysis to the migration
to the
new architecture, so as not to disrupt day-to-day operations. The
plan
targeted the least complex opportunities first, starting with file
and print
services. Guardian initially had more than 30 servers providing
file and print
services. These were consolidated into just two servers

clustered in a high-
availability, fault-tolerant configuration. For more complex
parts of the plan,
the team opted to do some of the consolidation in New York,
and only then
move the servers to Bethlehem after the consolidation had
settled down.
The initial consolidation and relocation project yielded tangible
benefits
to Guardian in terms of reduced hardware and personnel
requirements. But
the benefits extended well beyond these initial objectives. The
mindset of
solving new problems efficiently and in the context of the
existing
infrastructure had taken hold. Guardian no longer automatically
takes orders
for new servers to support applications as it did throughout the
1990s.
Instead, Guardian analyzes each new application requirement
and attempts
to support it with the existing hardware/software suite or with
minimal
upgrades and extensions.

The total cost of the data centered consolidation project was
$4.5
million, but the company saved more than $3 million in 2002,
offsetting
much of that cost. Even greater savings were realized during
each of the
following two years.
Further Consolidation
In 2010, Guardian embarked on a second major data centered
consolidation
initiative. The maturation of virtualization technologies and
evolution of high-
bandwidth WAN connections encouraged Guardian to
consolidate six data
centers into two [MITC11]. This is illustrated in Figure C7.2.
Guardian will
C7-6
consolidate its mission critical data processing infrastructure
into one
primary data center that it will own. The company plans to lease
a second

modular pod for use as its second data center. Pod data centers
can be
thought of as data centers in a box. These can be configured by
vendors to
customer specifications and delivered as a container that looks
similar to
refrigerated box car or multi-modal shipping container stacked
on ships or
carried by tractor trailer trucks. Pods are energy efficient but
can be a
cramped for human movement.
C7-7
In addition to moving to a much leaner data center
infrastructure,
Guardian is migrating from Unix to Linux. It has also started to
move some
of its applications to the cloud [MITC11]. By the beginning of
2012, Guardian
had moved 18 back-end applications to SaaS and had begun
transitioning e-

mail, HRIS, and IT services into the cloud. The breadth of
Guardian's move
to the cloud put the company on the leading edge among
Fortune 250
organizations [MITC12].
Guardian is using the IDEAS Advantage services from Ideas
International to help it make decisions about remodeling its data
center
infrastructure [GOLI11]. These sophisticated tools in
combination with
Guardian’s commitment to cloud services indicate that the
insurance
company’s data center consolidation initiatives are far from
over. Guardian
has not yet moved its core ERP systems to the cloud, but even
this is under
consideration.
Discussion Points
1. Do some Internet research on the reasons why businesses
generally
invest in data center consolidation projects. What benefits do
they
commonly hope to realize? How do Guardian’s rationale for
consolidating data centers compare to those of other businesses?

2. Getting outside consultants to manage data center
consolidation
projects is a common practice. Discuss the pros and cons of
using
consultants to manage data center consolidation projects?
3. How/why has virtualization fueled business interest in data
center
consolidation?
4. Why is the availability of high-speed, high bandwidth
communications
an important consideration in data center consolidation plans
and
decision-making?
5. Do some Internet research on modular (pod) data centers.
Summarize
the advantages of disadvantages of modular data centers.
C7-8
6. Guardian is consolidating from six to two data centers
supplemented
with SaaS cloud services. As the company continues to move

applications to the cloud, could it consolidate to zero data
centers?
Why or why not?
7. Do you think that winning multiple CIO 100 awards has
encouraged
Guardian’s IT executives to recommend risky IT projects? Why
or why
not?
Sources
[CIOZ12] CIO Zone.”Guardian CIO on Aligning IT, Business.”
Retrieved
online at:
http://www.ciozone.com/index.php/Management/Guardian-CIO-
On-Aligning-IT-Business.html.
[GOLI11] Golia, N. “Guardian Life Using Analytics to Assist
Data Center
Planning. Insurance Technology, September 1, 2011. Retrieved
online at:
http://www.insurancetech.com/architecture-
infrastructure/231600651
[MITC11] Mitchell, R. “Cloud to Lower Bar, Intensify
Competition.”
Computerworld, March 7, 2011. Retrieved online at:
http://blogs.computerworld.com/17935/cloud_to_lower_bar_inte
nsify_comp
etition
[MITC11] Mitchell, R. “Best Practices for Scaling up SaaS to
the Cloud.

Techworld, February 14, 2012. Retrieved online at:
http://features.techworld.com/sme/3337405/best-practices-for-
scaling-up-
saas-in-the-cloud/
[MUSI02] Musich, P. “Project Gets Helping Hand.” eWeek,
November 25,
2002. www.eweek.com.
[PRNE11] PR Newswire. “Guardian Life Recognized by CIO
Magazine for
Third Consecutive Year in CIO 100 Awards.” Retrieved online
at:
http://www.prnewswire.com/news-releases/guardian-life-
recognized-by-cio-
magazine-for-third-consecutive-year-in-cio-100-awards-
54985272.html
On-Aligning-IT-Business.html
On-Aligning-IT-Business.html
http://www.insurancetech.com/architecture-
infrastructure/231600651
nsify_competition
nsify_competition
scaling-up-saas-in-the-cloud/
scaling-up-saas-in-the-cloud/
recognized-by-cio-magazine-for-third-consecutive-year-in-cio-
100-awards-54985272.html

recognized-by-cio-magazine-for-third-consecutive-year-in-cio-
100-awards-54985272.htmlCASE STUDY 7Further
ConsolidationDiscussion PointsSources
Calculation - Rate of Return for Stocks and Bonds
FIN/571
Running head: CALCULATION - RATE OF RETURN FOR
STOCKS AND BONDS
1
CALCULATION - RATE OF RETURN FOR STOCKS AND
BONDS
4
Calculation - Rate of Return for Stocks and Bonds
Stock Valuation
1. “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.”
1a) Percentage total return = (Dividends paid + Change in
market value) / Initial stock price
Percentage total return = ($2 + ($125-$100))/ $100 = $27 / $100
= 0.27 or 27%
1b) Capital gains yield = (Ending share price – Initial share
price)/Initial share price
Capital gains yield = ($125 - $100) / $100 = $25 / $100 =

.25 or 25%
1c) Dividend yield = Dividend per share earn during the
year / the initial stock price
Dividend yield = $2.00 / $100 = 0.02 or 2%
Total Return
2. “You bought a share of 4 percent preferred stock for $100
last year. The market price for your stock is now $120. What
was your total return for last year?”
Total return = (Dividend paid + Change in market value) /
Initial stock price
Total return = ((4% x $100) + ($120 - $100)) / $100 = ($4 +
$20) / $100 = 0.24 or 24%
CAPM
3. “A stock of 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?”
Expected rate of return = Risk-free rate + (Beta x (Expected
market rate – Risk-free rate))
Expected rate of return = 5% + (1.20 x (12% - 5%) = 5% + (1.20
x 7%) = 5% + 8.4%
Expected rate of return = 13.4%
WACC
4. “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 = (Weight of Equity x Cost of Equity x (1 – Tax rate)) +
(Weight of Debt x Cost of debt)
WACC = (80% x 12% x (1 – 30%)) + (20% x 7%) = (6.72% +
1.4%) = 8.12%
FLOTATION COSTS
5. “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 percent. The flotation cost on new debt is 4 percent.
What is the initial cost of the plant if the company raises all

equity externally?”
% of Debt = 0.75 / (1+0.75) = 42.86%
% of Equity = 100% - % of Debt = 100% - 42.86% = 57.14%
Plant funded through debt: 42.86% x $125 million =
$53,575,000
Flotation cost on Debt = $53,575,000 x 4% = $2,143,000
Plant funded through equity: 57.14% x $125 million =
$71,425,000
Flotation cost on equity = $71,425,000 x 10% = $7,142,500
Total Flotation cost = $2,143,000 + $7,142,500 = $9,285,5000
Initial Cost = $125,000,000 + $9,285,5000 = $134,285,500

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