Question

 

Watson Power Co. needs to raise $2 million as a basic source of long-term funds to run their business. The firm has the following alternatives:

Bond: to sell 20 years bond, 10% coupon rate (with semiannual coupon payment) on par value $1,000, issued at 6% discount, floatation cost is 1.5% of par and corporate tax rate is 25%.

Preferred stock: to issue stock that has a 7.5% annual dividend, floatation cost of 3.5% of $100 par value and the price of 2.5% above par.

Common stock: the current dividend is $1.50 and the market price is $56 per share. The annual growth rate of dividend is 7% and the floatation cost is $2.20.

a) Calculate the cost of each alternative of financing.

b) Which alternative should Watson Power Co. choose? Why?

Answer 1

(a.) Calculation of Cost of each alternative source of financing :

Cost of Bond :

Using Financial Calculator

=RATE(nper,pmt,pv,fv)

where nper is Number of years to maturity i.e 20 * 2 = 40 (Multiplied by 2 As coupons are paid semi annually)

pmt is Interest payment i.e 1000 * 10% = 100 / 2 = 50 (Divided by 2 As coupons are paid semi annually)

pv is Current Market Price

= 925 [Par value - Dicount - Flotation Cost] i.e  [1000 - (1000 * 6%) - (1000 * 1.5%)]

Note : pv should be taken as negative.

fv is face value i.e 1000 (Assumed)

=RATE(40,50,-925,1000)

therefore ,Before tax cost of Debt is 5.46527% (Semi Annual)

Before tax cost of Debt is 5.46527% * 2 = 10.9305% (Annual)

After tax cost of Debt = Before tax cost of Debt * (1 - Tax rate )

=10.9305% * (1 - 0.25)

= 8.20%

Using Approximate formula :

Cost of Debt = {Coupon + [(Face value - Net Proceeds) / Number of years of maturity] } / [(Face value + Net Proceeds) / 2]

= {50 + [(1000 - 925) / 40] } / [(1000 + 925) / 2 ]

= 51.875 / 962.5

= 5.389610389% (Semiannnual)

= 5.389610389% * 2 = 10.78%

After tax cost of Debt = 10.78% * (1 - 0.25) = 8.08%

Calculation of Cost of Preferred Stock

Cost of Preferred Stock = Annual Dividend / ( Current Market Price - Flotation Cost + Premium)

= (100 * 7.5%) / [100 - (100 * 3.5%) + (100 * 2.5%)]

= 7.5 / 99

= 0.0758 or 7.58%

Calculation of Cost of Equity

Cost of Common Equity = [Expected Dividend / (Market Price )] + growth rate

= {[(1.50 * 1.07)] / [ 56 - 2.20 ] + 0.07

= 9.98%

(b.) Watson Power should use Preferred stock to raise long term finance as it has the lowest cost among all.