Question

Q1: Use the following information to answer the next five parts:

The Global Advertising Company has a marginal tax rate of 40%.

The company can raise debt at a 12% interest rate.

The last dividend paid by Global was $1.10. Global’s common stock is selling for $8.30 per share, and its expected growth rate in earnings and dividends is 4%.

Global plans to finance all capital expenditures with 30% debt and 70% equity.

a. What is the after-tax cost of debt for the Global’s Dairies?

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

c. 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?

d. Two independent projects are available: Project A has a rate of return of 13%, while project B’s return is 14%. These two projects are equally risky and also about as risky as the firm’s existing assets. Which projects should the company accept?

e. 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

The Global Advertising Company has a marginal tax rate of 40%.

The company can raise debt at a 12% interest rate.

The last dividend paid by Global was $1.10. Global’s common stock is selling for $8.30 per share, and its expected growth rate in earnings and dividends is 4%.

Global plans to finance all capital expenditures with 30% debt and 70% equity.

a. What is the after-tax cost of debt for the Global’s Dairies?

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

Before tax cost of debt = 12%

Tax rate = 40%

After tax cost of debt = 12 * ( 1 - 0.40) = 12 * 0.60 = 7.2%

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

Cost retained earning has no issuing cost. So it is usually lower than cost of new common stock

Cost of equity ( retained earning) = (D1 / M ) + G

Where,

D1 = next year dividend = last dividend + growth rate = 1.10 + 4% = 1.144

M = current price = 8.30

G = growth rate = 4%

Cost of equity ( retained earning) = 1.144 / 8.30 + 0.04

Cost of equity ( retained earning) = 0.1378 + 0.04 = 0.1778 = 17.78%

c. 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?

WACC = ( cost of debt * weight ) + cost of equity * weight )

capital expenditures with 30% debt and 70% equity.

WACC = ( 7.2 * 30% ) + ( 17.78% * 70% )

WACC = 2.16 + 12.446 = 14.61%

d. Two independent projects are available: Project A has a rate of return of 13%, while project B’s return is 14%. These two projects are equally risky and also about as risky as the firm’s existing assets. Which projects should the company accept?

Both project are not accepted, Because both project return are lower than company cost of capital. If it accept the company has loss occur.

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

Cost of equity ( new stock ) = (D1 / ( M - F ) + G

Where,

D1 = next year dividend = last dividend + growth rate = 1.10 + 4% = 1.144

M = current price = 8.30

G = growth rate = 4%

F = flotation cost = 1.5% of current price = 8.30 * 1.5% = 0.1245

Cost of equity ( New stock)   = 1.144 / (8.30 - 0.1244 ) + 0.04

Cost of equity ( New stock)   = 1.444 / 8.1756 + 0.04

Cost of equity ( New stock)   = 0.1766 + 0.04 = 0.2166 = 21.66%