TABLE 3 Financing Cost Data Long-term debt: The firm can raise $700,000 of addit
ID: 2738917 • Letter: T
Question
TABLE 3
Financing Cost Data
Long-term debt: The firm can raise $700,000 of additional debt by selling 10-year, $1,000, 12% annual interest rate bonds to net $970 after flotation costs. Any debt in excess of $700,000 will have a before-tax cost, rd, of 18%.
Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $60 par value and a 17% annual dividend rate. It will net $57 per share after flotation costs.
Common stock equity: The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm’s stock is currently selling for $20 per share. The firm expects to have $1,300,000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $16 per share after underpricing and flotation costs.
TO DO
a. Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete the table.
Source of capital
Range of new financing
After-tax cost (%)
Long-term debt
$0–$700,000
_________
$700,000 and above
_________
Preferred stock
$0 and above
_________
Common stock equity
$0–$1,300,000
_________
$1,300,000 and above
_________
Financing Cost Data
Long-term debt: The firm can raise $700,000 of additional debt by selling 10-year, $1,000, 12% annual interest rate bonds to net $970 after flotation costs. Any debt in excess of $700,000 will have a before-tax cost, rd, of 18%.
Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $60 par value and a 17% annual dividend rate. It will net $57 per share after flotation costs.
Common stock equity: The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm’s stock is currently selling for $20 per share. The firm expects to have $1,300,000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $16 per share after underpricing and flotation costs.
Explanation / Answer
For Long Term Debt upto $700,000
The interest paid on bonds =12% of the Face Value =12% x 1000 = $120
Since the amount raised net of floatation costs is $970 the effective cost of debt is, Rd = 120/970 = 12.37%
Since the tax rate is not given we assume a tax rate of 30%
The post tax cost of debt is = Rd (1-T) = 12.37%(1-30%) = 8.66%
For Long Term Debt in excess of $700,000
For debt raised in excess of $700,000, the pre-tax cost of debt is 18%
Post Tax cost of debt is = 18%(1-30%) = 12.6%
For Preferred Stock
Par value for the stock, P =$60
Dividend rate, D =17%
Issuance price post flotation cost , F = $57
Dividend paid in dollar amount, d= 17% of P = 17% x 60 = $10.2
Cost of preferred equity, Rpe = 10.2/57 = 17.89%
Since the preferred stock dividend is not tax deductible, the post tax cost of equity is also 17.89%
Cost of Common equity
For common equity upto $1,300,000
Current stock price, P = $20
Dividend and Earnings growth rate, g =15%
Since the dividend paid is not given we assume a dividend paid end of year =$2
For common stock above
Rs = (D1/P0)+g = ((2 x(1+15%)/20)+15% = 26.5% (this will be post tax as common equity is not subject to TAX DEDUCTIONS)
where D1 is the dividend paid in one year time from now
For common equity more than $1,300,000
The price of each common stock issued = $16
Substituting in the formula above
Rs = (2 x (1.15))/(16)+15% = 29.38% (this the cost of equity post tax)
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