Question

Use the above information to answer Questions 1 - 17. Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools. This new machine costs $1,000,000 and will be depreciated over 10 years on a straight-line basis toward zero salvage value. KHC paid a consulting company $50,000 last year to help them decide whether there is sufficient demand for the special tools. In addition to the investment on the machine, KHC also invests $30,000 in net working capital. The company pays $45,000 in interest expenses annually. KHC has estimated the performance of the new machine and believes that the new machine will produce $350,000 per year in sales, $130,000 per year in cost of goods sold, and $25,000 per year in administrative expenses. In order to get an estimate of cost of capital, KHC collect the following information. KHC has 310,400 shares of common stock outstanding, 15,000 shares of preferred stock outstanding, and 8,000 issues of corporate bond outstanding. The bonds have face value $1,000 and coupon rate 6%. The bonds make semiannual coupon payments, have 25 years to maturity, and sell for 131.4236% of par. The common stock sells for $56 per share and has a beta of 1.05. KHC’s next common stock dividend is expected to be $2.80 per share, and the common stock dividend is expected to grow at 7.7% indefinitely. The preferred stock sells for $72 per share and pays $4.5 annual dividend. The market risk premium is 8%, T-bills are yielding 4.5%, and KHC’s tax rate is 25%.

What is the cost of preferred stock for KHC? a. 6.25% b. 16% c. 6.25 d. 16

What is the after-tax cost of debt for KHC? a. 3% b. 2% c. 5% d. 4%

What is KHC's cost of equity estimated by using the capital asset pricing model? a. 10.2% b. 12.9% c. 14.1% d. 15.4%

What is KHC's cost of equity estimated by using the dividend growth model? a. 10.2% b. 12.7% c. 13.1% d. 9.5%

What is KHC's market value capital structure? a. $31,517,788 b. $37,361,828 c. $28,976,288 d. $19,285,318

Answer 1

Cost of preferred stock for KHC

Cost of preferred stock for KHC = (Annual Preferred Dividend / Market price per share) x 100

= ($4.50 / $72.00) x 100

= 6.25%

“Cost of preferred stock for KHC = (a). 6.25%”

After-tax cost of debt for KHC

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 6% x ½]	PMT	30
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [25 Years x 2]	N	50
Bond Price [-$1,314.236]	PV	-1,314.236

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 4.00%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 4.00% x (1 – 0.25)

= 4.00% x 0.75

= 3.00%

“After-tax cost of debt for KHC = (a).3%”

KHC's cost of equity estimated by using the capital asset pricing model

KHC's cost of equity estimated by using the capital asset pricing model = Risk-free Rate + (Beta x Market Risk Premium)

= 4.5% + (1.05 x 8%)

= 4.5% + 8.4%

= 12.9%

“KHC's cost of equity estimated by using the capital asset pricing model = (b). 12.9%”

KHC's cost of equity estimated by using the dividend growth model

KHC's cost of equity estimated by using the dividend growth model = (Dividend in next year / Current Market Price) + Growth Rate

= (D1 / P0) + g

= ($2.80 / $56.00) + 0.0770

= 0.05 + 0.0770

= 0.1270 or

= 12.7%

“KHC's cost of equity estimated by using the dividend growth model = (b). 12.7%”

KHC's market value capital structure

KHC's market value capital structure = Market Value of the Bond + Market Value of the Preferred Stock + Market Value of Common stock

= [8,000 Bonds x $1,1314.236] + [15,000 Preferred Shares x $72 per Bond] + [310,400 Common shares x $56 per share]

= $1,05,13,888 + $10,80,000 + $1,73,82,400

= $2,89,76,288

“KHC's market value capital structure = (c). $28,976,288”