Question

1. The following data apply to this and the next two problems. The Global Advertising Company had net income after interest but before taxes of $50,000 this year. The marginal tax rate is 34%, and the dividend payout ratio is 45%. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises more than $8,000 of debt, a 15 percent interest rate will apply. The last dividend paid by Global was $2.25. Global's common stock is selling for $29.50 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and a 70 percent equity. What is Global's cost of retained earnings?

   		11%
   		12%
   		13%
   		14%

1. What is the cost of common equity raised by selling new stock?

   		11%
   		12%
   		13%
   		14%

1. What is the cost of debt financing (assume that the firm is raising $5,000)?

   		15%
   		12%
   		9.9%
   		7.9%

Answer 1

Answer :

Calculation of Cost of Retained Earnings

Cost of Retained Earnings = (Expected Dividend / Current Price without floatation cost) + growth rate

Growth rate = 5% or 0.05

Expected Dividend = Current Dividend * (1 + growth rate)

= 2.25 * (1 + 0.05)

= 2.3625

Current Price without floatation cost = $29.50

Cost of Retained Earnings = (2.3625 / 29.50) + 0.05

= 0.08 + 0.05

= 0.13 or 13%

Calculation of Cost of Common Equity raised by selling new stock

Cost of Common Equity = (Expected Dividend / Current Price with floatation cost) + growth rate

Growth rate = 5% or 0.05

Expected Dividend = Current Dividend * (1 + growth rate)

= 2.25 * (1 + 0.05)

= 2.3625

Current Price with floatation cost = $29.50 - (10% * 29.50)

= 29.50 - 2.95

= 26.55

Cost of Common Equity = (2.3625 / 26.55) + 0.05

= 0.09 + 0.05

= 0.14 or 14%

Calculation of cost of debt financing (assume that the firm is raising $5,000)

As firm is raising $ 5000 therefore rate of interest is 12 %

Cost of Debt = Interest rate * (1 -Tax rate)

= 12% (1 -0.34)

= 7.9%