Question

The treasurer of a new venture, Certus, Inc., is trying to determine how to raise $6 million of long-term capital. Her investment adviser has devised the alternative capital structures shown below:

Alternative A $2,000,000 9% debt $4,000,000 Equity

Alternative B $4,000,000 12% debt $2,000,000 Equity

If alternative A is chosen, the firm would sell 200,000 shares of common stock to net $20 per share. Stockholders would expect an initial dividend of $1 per share and a of 7 percent. Under alternative B, the firm would sell 100,000 shares of common stock to net $20 per share. The expected initial dividend would be $0.90 per share, and the anticipated dividend growth rate 12 percent. Assume that the firm earns a profit under either capital structure and that the effective tax rate is 50 percent.

a) What is the cost of capital to the firm under each of the suggested capital structures? Explain your result.

( b )Explain the logic of the anticipated higher interest rate on debt associated with alternative B. (c) Is it logical for shareholders to expect a higher dividend growth rate under alternative B? Explain your answer.

Answer 1

Alternative 1

Cost of Debt (Kd) = I*(1-T) where , I = Interest charged , T= Tax Charged

Kd = 9%*(1-50%) = 4.5%

Cost of Equity (Ke) = D1/P0 + 7% Where, D1 = Expected Dividend , P0 = Price of Stock

Ke = (1/20)% +7% = 12%

Weighted average cost of Capital (WACC)= Kd*Weighted portion of debt +Ke*Weighted portion of equity

WACC = 4.5 *200000/6000000 + 12 *4000000/6000000

= 1.50% +8% = 9.50%

Alternative 2

Cost of Debt (Kd) = I*(1-T) where , I = Interest charged , T= Tax Charged

Kd = 12%*(1-50%) = 6%

Cost of Equity (Ke) = D1/P0 +G Where, D1 = Expected Dividend , P0 = Price of Stock, G=Growth

Ke = (0.9/20)% +12% = 16.5%

Weighted average cost of Capital (WACC)= Kd*Weighted portion of debt +Ke*Weighted portion of equity

WACC = 6% *4000000/6000000 + 16.5% *2000000/6000000

= 4% + 5.50% = 9.50%

In both the Alternatives overall Cost of Capital is Same.

b) Because, the company plan to finance majority portion of there Risky venture thru Debt. Therefore more Risk is associated in this alternative. Therefore,Cost of Debt is Increasing.

c) No, because in the alternative 1 the Shareholder has to expect more dividend because Overall cost of Capital of both the Alternaives are same but in Alternative 1 Cost of Debt is less. Thereover Shareholder expect more dividend.