Question 17 Merrill Lee Limited has the following information and a tax rate of

Question

Question 17Merrill Lee Limited has the following information and a tax rate of 30 percent

A. Determine the following for the company: (a) Total Market value

Debt

3,000, 6 percent coupon bonds outstanding, $1,000 par value, 12 years to maturity, selling for 80 percent of par, the bonds make semi- annual payments

Common stock

100,000 shares outstanding, selling for $55 per share; the beta is 1.20

Preferred stock

19,000 shares of 6 percent preferred stock outstanding, currently selling for $110 per share

Market

6 percent market risk premium and 4 percent risk-free rate

B. Explain why the (i) cost of retained earnings and (ii) cost of debt, are lower than the cost of external equity for the company.

Debt

3,000, 6 percent coupon bonds outstanding, $1,000 par value, 12 years to maturity, selling for 80 percent of par, the bonds make semi- annual payments

Common stock

100,000 shares outstanding, selling for $55 per share; the beta is 1.20

Preferred stock

19,000 shares of 6 percent preferred stock outstanding, currently selling for $110 per share

Market

6 percent market risk premium and 4 percent risk-free rate

Explanation / Answer

Market value = 9,990,000

B. Cost of retained earnings is lower since there are no additional costs or floatation costs to raise new capital

Cost of debt is lower because debt holders expect a fixed rate of return that needs to be serviced irrespective of the performence. So this rate is lower

Market value equity               5,500,000 debt               2,400,000 preferred share               2,090,000 total         9,990,000.00

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