Question

Use the information to answer the following questions. • The Global Advertising Company has a marginal tax rate of 40%. • The company can raise debt at a 8% interest rate. • The last dividend paid by Global was $1.10. Global’s common stock is selling for $7.93 per share, and its expected growth rate in earnings and dividends is 4%. • Global plans to finance all capital expenditures with 20% debt and 80% equity.

What is the after-tax cost of debt for the company?

What is Global's cost of common stock if it can use retained earnings rather than issue new common stock?

What is the firm's weighted average cost of capital if the firm has sufficient retained earnings to fund the equity portion of its capital budget?

Two independent projects are available: Project A has a rate of return of 19%, while project B’s return is 18%. These two projects are equally risky and also about as risky as the firm’s existing assets. Which projects should the company accept?

Assume that the floatation cost of new stock issuing is 1.5%. What is Global's cost of common stock if it has to issue new common stock?

Answer 1

a. before-tax cost of the debt for the company is the interest rate at which it can raise new debt which is 8% in this case.

after-tax cost of debt for the company = before-tax cost of the debt*(1-marginal tax rate) = 8%*(1-0.40) = 8%*0.60 = 4.8%

after-tax cost of debt for the company is 4.8%.

b. Cost of common stock = [last dividend paid*(1+expected dividend growth rate)/current stock price] + expected dividend growth rate

Cost of common stock = [$1.10*(1+0.04)/$7.93] + 0.04 = [($1.10*1.04)/$7.93] + 0.04 = ($1.144/$7.93) + 0.04 = 0.1442622950819672 + 0.04 = 0.1843 or 18.43%

c. firm's weighted average cost of capital = weight of debt*after-tax cost of debt + weight of equity*cost of equity

Global plans to finance all capital expenditures with 20% debt and 80% equity. so, weight of debt is 20% and weight of equity is 80%.

firm's weighted average cost of capital = 0.20*4.8% + 0.80*18.43% = 0.96% + 14.744% = 15.70%

d. both Project A and B can be accepted because Project A's rate of return of 19% and Project B's rate of return of 18% are higher than firm's weighted average cost of capital of 15.70%. both projects will generate excess returns.