Question

Ameristar, Inc. can obtain funds for future investments through retained earnings, new issues of common stock, issuance of debt, and issuance of preferred stock. The Board of Directors believe an appropriate capital structure is one where funds are acquired in the following mix: 30% debt, 10% preferred stock, and 60% common stock. New issuance or flotation costs for the issuance of new securities amount to 3% for debt, 5% for preferred stock, and 10% for common stock. Ameristar has $180 million available in retained earnings and has a marginal tax rate of 33%.

If Ameristar sells a new issue of bonds that pay a 8.5% semi-annual coupon and mature in 20 years, these bonds can be sold for $1,212.68. If Ameristar sells a new issue of preferred stock that pay dividends at the rate of 8% with a par value of $50.00, these shares of preferred stock can be priced at $27.52. If Ameristar sells a new issue of common stock the dividends paid are expected to be the same as those dividends of the current common stock outstanding. Ameristar just paid a dividend on shares of their common stock of $1.54 (D0=$1.54) and in the recent past dividends have grown at a rate of 7%. This growth rate is expected to continue into the foreseeable future for common stock. Common stock currently sells for $15.12 a share.

What is Ameristar's after-tax cost of a new issue of debt?

What is Ameristar's cost of new preferred stock?

What is Ameristar's cost of retained earnings?

What is Ameristar's cost of new common stock?

Answer 1

Solution:

a)After Tax cost of debt

Where floatation cost is invloved,we take net purchase price

Net Purchase Price=Purchase Price*(1-Flotation Rate)

= $1,212.68(1-0.03)

=$1176.30

Cost of Debt=Annual Coupon Amount+(Face Value-Net Purchse Price)/Years to maturity]/(Face Value+Net Purchase Price)/2

=$1000*17%+($1000-$1176.30)/20/($1000+$1176.30)/2

=$170+(-$8.82)/1088.15

=0.148 or 14.8%

After Tax cost of debt=Cost of debt(1-Tax rate)

=14.8%(1-0.33)

=9.92%

Thus After Tax cost of debt is 9.92%

b)Calculation of Ameristar's cost of new preferred stock

Cost of preferred stock=Annual Preferred Dividend/Price of shares of preferred stock*(1-Flotation Rate)

=$50*8%/$27.52*(1-0.05)

=$4/26.144

=0.153 or 15.30%

Thus,Ameristar's cost of new preferred stock is 15.30%

c)Calculation of Ameristar's cost of retained earnings

Since the retained earning does not involve flotatation cost,hence formula for calculating cost of retianed(Ke) earning is;

Ke=(D1/Share Price)+Growth rate

D1=D0(1+growth rate)

=$1.54(1+0.07)

=$1.65

Ke=($1.65/$15.12)+0.07

=0.1790 or 17.90%

Thus,Ameristar's cost of retained earnings is 17.90%

d)Calculation of Ameristar's cost of new common stock

Since,issue of new shares of common stock involve flotation cost,hence formula for calculating cost of new common stock(Ke) is;

Ke=[D1/Share Price(1-Flotation Rate)]+Growth rate

=[$1.65/$15.12(1-0.10)]+0.07

=0.191 or 19.10%

Thus,Ameristar's cost of new common stock is 19.10%.