A firm has determined its optimal structure which is composed of the following s

Question

A firm has determined its optimal structure which is composed of the following sources and target market value proportions.

Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.

Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent.

5) The firm's before-tax cost of debt is ________. 5) _______

A) 7.7 percent B) 11.2 percent C) 12.7 percent D) 10.6 percent

6) The firm's after-tax cost of debt is ________. 6) _______

A) 7.7 percent B) 7 percent C) 6 percent D) 4.6 percent

7) The firm's cost of a new issue of common stock is ________.

A) 16.7 percent B) 10.2 percent C) 14.3 percent D) 17.0 percent

Explanation / Answer

5) We will find yield of bond first

Given data:

Time = 15yrs

Par value = $1000

Issue value = $1050

Flotation cost = 2%

Premium paid = $1000

Thus actual amount raised = 1050*0.98 = $1029

Thus yield of bond = 7.67%

Answer is A

6) After tax cost = (7.7 *(1-0.4)) = 4.6%

7) Growth in dividend = 10% calculated

Company must under-price stock by $2 and flotation cost of $1

Thus total cost =5+2+1 = $8

Thus cost of new issue = 8/75 = approx. 10.2%

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