Question

The Allied Group intends to expand the company's operation by making significant investments in several opportunities available to the group. Accordingly, the group has identified a need for additional financing in preferred and new common stock and new bond issues. The (Krf) risk-free rate for the company is 7%, and the appropriate tax rate is 40%. Also, the beta coefficient for the company is 1.3 and the market risk premium (Km) is 12%. New Debt (Kd) The company has been advised that new bonds can be sold on the market at par ($1000) with an annual coupon of 8%, for 30 years. New Common Stock Market analysis has determined that given the positive history of the firm, new common stock can be sold at $29 per share, with the last dividend being paid of $2.25 per share. The growth rate on any new delete the words highlighted in yellow common stock has been estimated at a constant rate of 15% per year for the next 3 years. Preferred Stock New Preferred Stock can be issued with an annual dividend of 10% of par and is paid annually and currently would sell for $90 per share. Tasks: Using the Capital Asset Pricing Model (CAPM), discuss and calculate the cost of new common stock (Ks). What would the dividend yield as a percentage (i.e., per dividend payment divided by the book value of a share of stock) today and a year from now if the dividend growth rate is 12%? What is the after-tax cost as a percentage (e.g., interest rate) of new debt today? What are your recommendations for raising capital based on your answers to the above questions plus considering other factors (e.g., current and potential changes in the economy locally, regionally, nationally and worldwide, changes in the demand and/or supply plus cost of materials, skilled labor, management and/or leadership, changes in interest, tax, inflation and/or supply of investment capital)?

Answer 1

1. Computation of cost of new common stock:

According to CAPM model,

ke = risk free rate + beta factor ( market premium - risk free rate)

Risk free rate = 7%

beta factor = 1.3

Market premium = 12%

ke = 7 + 1.3(12-7)

ke = 7 + 1.3*5

ke = 13.5%

Thus, cost of new common stock = 13.5%

2. Computatio of dividend yield :

According to dividend growth model,

ke = d1 / market price per share + g

Here,

d1 / market price per share = dividend yield

g = capital yield

d1 = $2.25

Market price per share = 29

Dividend yield = d1 / MPS

Dividend yield = 2.25/29

Dividend yield = 7.76

If the growth rate is 15% for 3 years dividends will be:

Year1 =$ 2.25

Year2 =$ 2.59

Year3 = $ 2.97

If the growth rate is 12% for 3 years dividends will be:

Year1 =$ 2.25

Year2 =$ 2.52

Year3 = $ 2.82

Dividend yield at 12%

Dividend yield = d1 / MPS

Dividend yield = 2.52/29

Dividend yield = $8.69%

Because the value of the stock is not increasing with the increase in dividends hence, dividend yield increases with the increase in dividends.

3.Computation of after tax cost of the new debt:

Interest = 8%

Tax rate = 40%

After tax cost of debt :-

kd = I (1-tax rate )

kd = 8 (1-0.4)

kd = 4.8%

4. Here, in the given question capital structure is comprised of 3 sources of financing namely equity stock , preferred stock , and debt capital. The debt financing is widely used because it is cheaper than equity. Thus, first a company tries to get funds internally then takes the help of debt capital and finally the equity capital. Equity capital financing is the riskiest financing and therefore be treated as last option. Only internal financing or debt financing cannot lead to profitable outcomes. An optimum combination of all will be profitable which provides minimum costs at given return and vice versa.

Other factors such as current and political changes, changes in demand and supply, and all other changes also affect the decision of optimum capital. For example let say in a given year interest rates tend to reduce, In such a case the firm may finance using its own funds. Taxes also affect the capital financing. Debts have tax advantage thus, their costs are reduced while equity does not have tax advantages therefore, they remains the same.

In the given question, information regarding the use of other influencing factors is missing therefore, we only consider the sources which provides the lowest cost with high returns.

Here, Allied groups has,

ke = 22.6%

kd = 4.8%

kp = 10%

Here kd has the lowest cost hence additional financing is done by raising debts.