Use the following information to answer questions 1-4 Jungle Recording Co. repor

Question

Use the following information to answer questions 1-4

Jungle Recording Co. reported after tax earnings of 4,000,000 avaible to common stock this year. From that the company pays a dividend of $4.00 on each of its 1,000,000 common shares outstanding. The book value of the company is $10 million. The capital structure of company inculdes $40 million debt. its tax rate is 40% the cost of debt 7%.

1. If the market price of common stock is $40 and dividends are expected to remain the same forever. What is the company's cost of equity?

a. 5%,b. 10%, c. 20%, d, 0, e infinite

2.What is the after tax cost of debt?

a. 10%,b. 7 ,c. 4.2 .d 8.5 e. 7.1%

3. what is the before tax weighted average cost of the capital?(show work)

4. what is the after tax weighted average cost of the capital?(show work)

Explanation / Answer

Answer:

1. Cost of equity = Ke = (D1/P)+g

Where = D = Expected Dividend in 1 year, P = Market price of share, g = Dividend growth rate

=> Ke = $(4/40)+0 = 10%(b)

2. Cost of Debt = Kd = KD(1-Tax rate) = 7%(1-0.4) = 4.2%(c)

3. Computation of Before tax weighted average cost of the capital:

Market value of equity = 1,000,000 common shares*$40 = $40,000,000

Market value of debt = $40,000,000

So weight of Debt:Equity = 50:50

Before tax weighted average cost of the capital = 0.10*50% + 0.7*50% = 0.85 = 8.5%

D) After tax cost weighted average cost of capital = 0.10*50% + 0.42*50% = 0.71 = 7.1%

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