ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS
11- 1A. (Individual or Component Costs of Capital) Compute the cost for the following sources of Financing: a. A bond that has a 1!""" par value (face value) and a contract or coupon interior rate of 1#$. A new issue would have a flotation cost of %$ of the 1!1#& mar'et value. (he bonds mature in 1" )ears. (he firm*s average ta+ rate is ,"$ and its marginal ta+ rate is ,-$. A new common stoc' issue that paid a 1..& dividend last )ear. (he par stoc' is 1&! and earnings per share have grown at a rate of /$ per )ear. rate is e+pected to continue into the foreseeable future. (he compan) constant dividend0earnings ratio of ,"$. (he price of this stoc' is now flotation costs are anticipated. value of the (his growth maintains a #/! but &$

b.

c.

Internal common e1uit) where the current mar'et price of the common stoc' is -,.&". (he e+pected dividend this coming )ear should be ,.#&! increasing thereafter at a .$ annual growth rate. (he corporation*s ta+ rate is ,-$. A preferred stoc' pa)ing a 1"$ dividend on a 1#& par value. If a new issue is offered! flotation costs will be 1#$ of the current price of 1&".

d.

e. A bond selling to )ield 1,$ after flotation costs! but prior to ad2usting for the marginal corporate ta+ rate of ,-$. In other words! 1,$ is the rate that e1uates the net proceeds from the bond with the present value of the future cash flows (principal and interest). 11- #A. (Individual or Component Costs of Capital) Compute the cost for the following sources of financing: a. A bond selling to )ield 3$ after flotation costs! but prior to ad2usting for the marginal corporate ta+ rate of ,-$. In other words! 3$ is the rate that e1uates the net proceeds from the bond with the present value of the future flows (principal and interest). A new common stoc' issue that paid a 1.#& dividend last )ear. (he par stoc' is #! and the earnings per share have grown at a rate of %$ per )ear. rate is e+pected to continue into the foreseeable future. (he compan) constant dividend0earnings ratio of -"$. (he price of this stoc' is now flotation costs are anticipated. value of the (his growth maintains a ,"! but 3$

b.

c.

A bond that has a 1!""" par value (face value) and a contract or coupon interest rate of 1,$. A new issue would net the compan) 3"$ of the 1!1#& mar'et value. (he bonds mature in #" )ears! and the firm*s average ta+ rate is ,"$ and its marginal ta+ rate is ,-$. A preferred stoc' pa)ing a .$ dividend on a 1#& par value. If a new issue is offered! the compan) can e+pect to net 3" per share. Internal common e1uit) where the current mar'et price of the common stoc' is ,/. (he e+pected dividend this coming )ear should be -! increasing thereafter at a &$ annual growth rate. (his corporation*s ta+ rate is ,-$.

d. e.

11- ,A.

(Cost of 41uit)) Falon Corporation is issuing new common stoc' at a mar'et price of #/. 5ividends last )ear were 1.," and are e+pected to grow at an annual rate of .$ forever. Flotation costs will be %$ of mar'et price. 6hat is Falon*s cost of e1uit)7

11- -A. (Cost of 5ebt) (emple is issuing a 1!""" par value bond that pa)s /$ annual interest and matures in 1& )ears. Investors are willing to pa) 3&" for the bond. Flotation costs will be 11$ of mar'et value. (he compan) is in a 13$ ta+ brac'et. 6hat will be the firm*s after-ta+ cost of debt on the bond7 11- &A. (Cost of 8referred 9toc') (he preferred stoc' of :ator Industries sells for ,& and pa)s #..& in dividends. (he net price of the securit) after issuance costs is ,#.&". 6hat is the cost of capital for the preferred stoc'7

11- %A. (Cost of 5ebt) (he 6algren Corporation is contemplating a new investment to be financed ,,$ from debt. (he firm could sell new 1!""" par value bonds at a net price of 3&". (he coupon interest rate is 1,$! and the bonds would mature in fifteen )ears. If the compan) is in a ,-$ ta+ brac'et! what is the after-ta+ cost of capital to 6algren for bonds7

11- .A. (Cost of 8referred 9toc') ;our firm is planning to issue preferred stoc'. (he stoc' sells for 1#"< however! if new stoc' is issued! the compan) would receive onl) 3.. (he par value of the stoc' is 1""! and the dividend rate is 1,$. 6hat is the cost of capital for the stoc' to )our firm7 11- /A. (Cost of Internal 41uit)) (he common stoc' for =+ford! Inc. is currentl) selling for ##.&". 5ividends last )ear were ./". Flotation costs on issuing stoc' will be 1"$ of mar'et price. (he dividends and earnings per share are pro2ected to have an annual growth rate of 1%$. 6hat is the cost of internal common e1uit) for =+ford7

11- 3A. (Cost of 41uit)) (he common stoc' for the >etterbrand Corporation sells for %". If a new issue is sold! the flotation cost is estimated to be 3$. (he compan) pa)s &"$ of its earnings in dividends! and a -.&" dividend was recentl) paid. 4arnings per share & )ears ago were &. 4arnings are e+pected to continue to grow at the same annual rate in the future as during the past & )ears. (he firm*s marginal ta+ rate is ,&$. Calculate the cost of (a) internal common and (b) e+ternal common stoc'. 11- 1"A. (Cost of 5ebt) :illian 9tationer) Corporation needs to raise %""!""" to improve its manufacturing plant. It has decided to issue a 1!""" par value bond with a 1&$ annual coupon rate and a 1"-)ear maturit). If the investors re1uire a 1"$ rate of return: a. b. c. d. 11- 11A. a. b. Compute the mar'et value of the bonds. 6hat will the net price be if flotation costs are 11.&$ of the mar'et price7 >ow man) bonds will the firm have to issue to receive the needed funds7 6hat is the firm*s after-ta+ cost of debt if its average ta+ rate is #&$ and its marginal ta+ rate is ,-$7 (Cost of 5ebt) ?ewor' problem 11-1"A assuming a 1" percent coupon rate. 6hat effect does changing the coupon rate have on the firm*s after-ta+ cost of capital7 6h) is there a change7

11- 1#A. (6eighted Cost of Capital) (he capital structure for the @ias Corporation is provided below. (he compan) plans to maintain its debt structure in the future. If the firm has a %$ after-ta+ cost of debt! a 1,.&$ cost of preferred stoc'! and a 13$ cost of common stoc'! what is the firm*s weighted cost of capital7 Capital 9tructure ( """) @onds 8referred stoc' Common stoc' 1!1"" #&" ,!."" &!"&"

SOLUTIONS FOR ALTERNATIVE PROBLEMS

(he following notations are used in this group of problems: 'ps 'cs 'ncs g 'd ( 5t 8" B8" 11- 1A. A A A A A A A A A a. "%) the cost of preferred stoc'. the cost of internall) generated common funds the cost of new common stoc'. the growth rate. the before-ta+ cost of debt. the marginal ta+ rate. dollar dividend per share! where 5" is the most recentl) paid dividend and 51 is the forthcoming dividend. the value (present value) of a securit). the value of a securit) less an) flotation costs incurred in issuing the securit) Bet price after flotation costs A 1!"&..&" 1!"&..&" A A 1!1#& (1 - .

t =1

1"

1#" (1 + ' d ) t

1!""" (1 + ' d )1"

'd A After ta+ cost of debt A After ta+ cost of debt A b. 'ncs A A A c. 'cs A A A

11."#$ 'd(1 - () 11."#$(1 - .,-) A ..#.$

51 B8"

C g

1..&(1 +."/) C ."/ #/.""(1 ."&)

.1&11 A 1&.11$
51 8"

C g

,.#& C .". -,.&"

.1--. A 1-.-.$

d.

'ps

A A A

5 B8"

.1" D 1#& 1&"(1 .1#)

1#.& 1,#

."3-. A 3.-.$ 'd(1 - () 1,$ (1 - .,-) /.&/$

e.

After ta+ cost of debt A A A a.

11- #A.

After ta+ 'd(1 - () cost of debt A After ta+ 3$(1 - ".,-) cost of debt A After ta+ &.3-$ cost of debt A A A A A
51 B8"

b.

'ncs 'ncs

C g

1.#&(1 +"."%) C "."% A 1"./&$ ,"(1 "."3)

c.

1!1#&(.3") 1!"1#.&"

1!"1#.&" A net price after flotation costs

'd A After ta+ cost of debt A After ta+ cost of debt A d. 'ps 'ps e. 'cs 'cs 11- ,A. 'ncs 'ncs 11- -A. A A A A A A

1," 1!""" t C (1 + ' d ) #" t = 1 (1 + ' d ) 1#./,$

#"

'd(1 - () 1#./,$ (1 - ".,-) A /.-.$

5 B8"
/..& A 3..#$ 3" 51 8"

C g

C "."& A 1&.&#$ ,/
51 B8"

C g

1.,"(1 +".".) C ".". A .1##3 A 1#.#3$ #/(1 "."%)

3&" (1 - ".11) A

/-&.&" A the net price (value less flotation costs).

/-&.&" 'd

A A

t =1 (1 + ' d )

1&

/"
t

1!""" (1 + ' d )1&

1"."-$

After ta+ cost of debt A 1"."-$ (1 - ".13) A /.1,$ 11- &A. 11- %A. 'ps B8" 3&" A A
5 B8"

#..& A /.-%$ ,#.&"

t =1
1&

It (1 + ' d )
1," (1 + ' d ) t
t

E (1 + ' d ) n 1!""" (1 + ' d )1&

t =1

9ince the net price on the bonds! 3&"! is less than the 1!""" par value! the before-ta+ cost of the debt must be greater than the 1,$ coupon interest rate ( 1," F 1!"""). 'd After ta+ cost of debt 11- .A. A A 1,./1$ 'd(1 - () A 1,./1$(1 - .,-) A 3.11$
5 B8"
1, 3.

Cost of preferred stoc' ('ps) A A A

5ividend A Bet 8rice
1,$ + 1"" A 3.

1,.-"$

11- /A.

'cs

51 8 "

C g

A A 11- 3A.

"./"(1 +".1%) C ".1% ##.&"

.#"1# A #".1#$

If the firm pa)s out &"$ of its earnings in dividends! its recent earnings must have been 3 ( -.&" dividend divided b) .&).

(hus! earnings increased from & to 3 in & )ears. Gsing Appendi+ C and loo'ing for a table value of .&&% ( &0 3)! the annual growth rate is appro+imatel) 1#$. a. Cost of internal common funds ('cs): 'cs A A A A b.
5 1 C g 8 " -.&"(1 +.1#)

%"
&."C .1# %"

C .1#

.#"- A #."-$

Cost of e+ternal common (new common) stoc'! 'ncs

5 'ncs A 1 C g B8 " &."C .1# %"(1 "."3) &."C .1# &-.%"

A A

A .#1#, A #1.#,$ 11- 1"A. a. 8rice (8") A A b. B8" A A c. Bumber of @onds A 1"""(.,/%)

t =1

1"

1&" 1!""" C t (1 + ".1") 1" (1 + ".1")

1&"(%.1-&) C 1!,"...&

1!,"...&(1 - ".11&) 1!1&..,% A A

%""!""" 1!1&..,%

&1/ @onds

d.

Cost of debt: 1!1&..,% 'd A A

t =1

1"

1&" 1!""" t C (1 + ' )1" (1 + ' d ) d

.1#.#"$

After ta+ cost of debt A 11- 11A. a. 1.

1#.#"$(1 - ".,-) A /."&$ 8rice (8") A A A

t =1
1!""" (.,/%)

1"

1!""" 1"" t C (1 + ".1")1" (1 + ".1")

1"" (%.1-&) C 1!""".""

#.

B8"

A A

1!"""."" (1 - ".11&) //&."" A A

%""!""" //&.""

,.

Bumber of @onds

%./ @onds
1""
t

-.

Cost of debt: //&."" 'd A A

t =1 (1 + ' d )

1"

1!""" (1 + ' d )1"

1#."-$

After ta+ cost of debt A b. 11- 1#A.

1#."-$(1 - ".,-) A ..3&$

(here is a ver) slight decrease in the cost of debt because the flotation costs associated with the higher coupon bond are higher. @ias CorporationH6eighted Cost of Capital Capital 9tructure 1!1"" #&" ,!."" 6eights ".#1./ "."-3& "..,#. Individual Costs %."$ 1,.&$ 13."$ 6eighted Costs 1.,1$ ".%.$ 1,.3#$

@onds 8referred 9toc' Common 9toc' &!"&" 1."""" 1&.3"