As a result of current interest rates the bonds can

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Unformatted text preview: per bond will be incurred in this process. The firm is in the 40% tax bracket. a. Find the net proceeds from sale of the bond, Nd. b. Show the cash flows from the firm’s point of view over the maturity of the bond. c. Use the IRR approach to calculate the before-tax and after-tax costs of debt. d. Use the approximation formula to estimate the before-tax and after-tax costs of debt. e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why? LG2 11–3 Cost of debt using the approximation formula For each of the following $1,000par-value bonds, assuming annual interest payment and a 40% tax rate, calculate the after-tax cost to maturity using the approximation formula. Discount ( ) or premium ( ) Bond 20 years $25 $20 B 16 40 10 10 C 15 30 15 12 D 25 15 Par 9 E 11–4 Underwriting fee A LG2 Life Coupon interest rate 22 20 60 11 9% The cost of debt using the approximation formula Gronseth Drywall Systems, Inc., is in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case, the bonds will have a $1,000 par value and flotation costs will be $30 per bond. The company is taxed at 40%. Calculate the after-tax cost of financing with each of the following alternatives. Alternative Coupon rate Time to maturity Premium or discount A 9% 16 years $250 B 7 C D 5 50 6 7 par 5 10 75 496 PART 4 Long-Term Financial Decisions LG2 11–5 Cost of preferred stock Taylor Systems has just issued preferred stock. The stock has a 12% annual dividend and a $100 par value and was sold at $97.50 per share. In addition, flotation costs of $2.50 per share must be paid. a. Calculate the cost of the preferred stock. b. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00 after flotation costs, what is its cost? LG2 11–6 Cost of preferred stock Determine the cost for each of the following preferred stocks. Preferred stock Par value Sale price Flotation cost Annual dividend A $100 $101 $9.00 11% B 40 38 $3.50 8% C 35 37 $4.00 $5.00 D 30 26 5% of par $3.00 E 20 20 $2.50 9% LG3 11–7 Cost of common stock equity—CAPM J&M Corporation common stock has a beta, b, of 1.2. The risk-free rate is 6%, and the market return is 11%. a. Determine the risk premium on J&M common stock. b. Determine the required return that J&M common stock should provide. c. Determine J&M’s cost of common stock equity using the CAPM. LG3 11–8 Cost of common stock equity Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2004). The dividends for the past 5 years are shown in the following table. Year Dividend 2003 $3.10 2002 2.92 2001 2.60 2000 2.30 1999 2.12 After underpricing and flotation costs, the firm expects to net $52 per share on a new issue. a. Determine the growth rate of dividends. b. Determine the net proceeds, Nn, that the firm actually receives. CHAPTER 11 The Cost of Capital 497 c. Using the constant-growth valuation model, determine the cost of retained earnings, kr. d. Using the constant-growth valuation model, determine the cost of new common stock, kn. LG3 11–9 Retained earnings versus new common stock Using the data for each firm shown in the following table, calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model. Dividend growth rate Projected dividend per share next year Underpricing per share Flotation cost per share 8% Firm A $50.00 $2.25 $2.00 $1.00 B 20.00 4 1.00 0.50 1.50 C 42.50 6 2.00 1.00 2.00 D LG2 Current market price per share 19.00 2 2.10 1.30 1.70 LG4 11–10 The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c. a. Tax rate 40% b. Tax rate 35% c. Tax rate 25% d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital. LG4 11–11 WACC—Book weights Ridge Tool has on its books the amounts and specific (after-tax) costs shown in the following table for each source of capital. Source of capital Book value Long-term debt $700,000 Preferred stock 50,000 12.0 650,000 16.0 Common stock equity Specific cost 5.3% 498 PART 4 Long-Term Financial Decisions a. Calculate the firm’s weighted average cost of capital using book value weights. b. Explain how the firm...
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