USE THE FOLLOWING INFORMATION TO ANSWER QUESTIONS 6-13 (5 pts. each) The Ewing D
ID: 2668400 • Letter: U
Question
USE THE FOLLOWING INFORMATION TO ANSWER QUESTIONS 6-13 (5 pts. each)The Ewing Distribution Company (EDC) is planning a $100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed with debt, preferred stock and equity. The firm’s has 20,000 bonds with a $1,000 face value of current debt. The debt has a 12% coupon and 20 years remaining before maturity and is currently selling for $865. Ewing’s marginal tax rate is 40%.
EDC has 100,000 shares of $50 par value $3.50 preferred stock outstanding which has a current market price of $42. Ewing’s common stock paid a dividend of $2.10 per share this year and $2.00 the previous year. The current market price per share is $15, and the investment banking firm will charge a flotation fee of 10% if new shares are sold. The current risk-free rate is 7% and the market’s estimated rate of return is 15%. Ewing’s estimated beta is 1.2. Ewing expects to have $20 million of retained earnings available to finance the expansion.
Ewing’s Balance Sheet
Debt $ 20,000,000
Preferred Stock 5,000,000
Common equity 75,000,000
$ 100,000,000
7. Compute the after tax cost of preferred stock
8. Compute the cost of retained earnings : Discounted cash flow
Explanation / Answer
7. Computing the after-tax cost of preferred stock: Kp = Preferred stock Dividend / Current market price of Preferred stock where Preferred Stock dividend = $3.50 per share Current market price = $42 Kp = $3.50 / $42 = 0.083 or 8.3% The tax rate is irrelevant because the dividend are paid out of after-tax income so the cost is simply the dividend divided by the current market price. 8. Cost of retained earnings using Discountd cash flow approach: The formula for calculating the Cost of retained earnings using Discounted cash flow approach is Ks = (D1 / P0) + g where D1 = $2.10 P0 = $15 - 10% ($15) = $15 - $1.5 = $13.5 g = (D1 - D0) / D0 = ($2.10 - $2.00) / $2.00 = $0.10 / $2.00 = 0.05 or 5% Therefore, the growth rate is 5% Substituting the values in the above formula, we get Ks = ($2.10 / $13.5) + 0.05 = 0.2056 or 20.56% Therefore, the Cost of retained earnings is 20.56%Related Questions
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