Question

A firm that is in the 35% tax bracket forecasts that it can retain $4 million of new earnings plans to raise new capital in the following proportions:

60% from 30-year bonds with a flotation cost of 4% of face value. Their current bonds are selling at a price of 91 (91% of face value), have 4 years remaining, have an annual coupon of 7%, and their investment bank thinks that new bonds will have a 40 basis point (0.40%) higher yield-to-maturity than their current 4-year bonds due to their longer term. Any new bonds will be sold at par.

10% from preferred stock with a flotation cost of 5% of face value. The firm currently has an outstanding issue of $30 face value fixed-rate preferred stock with an annual dividend of $2 per share, and the stock is currently selling at $27 per share. Any newly issued preferred stock will continue with the $30 par-value, and will continue with the $2 dividend.

30% from equity. Their common dividend payout ratio is 60%, they paid a dividend of $1.59 per share yesterday, the dividend is expected to grow to $4.22 in 20 years, and is expected to continue this growth rate into the foreseeable future. The common stock has a current market price of $19, and their investment banker suggests a flotation cost of 7% of market value on new common equity.

Part 1: Calculate the after-tax cost of the new bond financing. ___________

Part 2: Calculate the after-tax cost of the new preferred stock financing. ______

Answer 1

Part 1: Calculate the after-tax cost of the new bond financing.

YTM of the existing bonds = RATE (Nper, PMT, PV, FV) = RATE (4, 7% x 100, -91% x 100, 100) = 9.83%
Hence, YTM of the new bonds = 9.83% + 0.40% = 10.23%
Since new bonds will be issued at par, hence coupon = 10.23%
Flotation cost = 4% of face value = 4% x 100 = 100
Current price of the new bonds = Par value - flotation cost = 100 - 4 = 96

Hence, YTM = RATE (Nper, PMT, PV, FV) = RATE (30, 10.23% x 100, -96, 100) = 10.68%
Hence, after tax cost of new bond financing = YTM x (1 - tax rate) = 10.68% x (1 - 35%) = 6.94%

Part 2: Calculate the after-tax cost of the new preferred stock financing.

Price net of flotation cost = 27 - 5% x 30 = $ 25.50
After tax cost of new preferred stock = Annual dividend / Price net of flotation = 2 / 25.50 = 7.84%