Question

Company A wants to expand to increase revenues while increasing economies of scale, which is why they wanted to purchase Company B. Company B agreed on a price of $125 million, but Company A has been doing business for a long time and has never taken a long-term debt. They plan on upholding that status. Company A plans on issuing bonds totaling $125 million to a Massachusetts-based insurance company. The 15-year bonds would pay 6.5% interest and a principal repayment of $6.25 million each year. The 6.5% interest rate would effectively be a rate of 4.225% on an after-tax basis, which is lower than the assumed 6% cost of dividends on the newly issued stock.

Would this be a good financing option? Why or Why not?

Answer 1

Answer- Cost of Debt (Kd) = 4.225%

Cost Of Equity = 6%

Wrt to the cost of capital it would be beneficial for Company A to Isuue Bonds Instead Of Equity Because of Lower Cost Of Capital.

- However we cannot use only Cost of Capital as a Basis for Decision Making. Because under Debt the Comapny A has to pay 6.25 Million $ Per annum and it may or may not be Possible for Company A to honour the same.

- On the Other hand if company A issues Equity then it is not required to pay any repayments to Equity shareholders except for in case of Liquidation.

Use of Debt has Lower cost but It also Increases the Chances of Bankruptancy.

Hence If we are only considering cost of capital for decision making then Debt is Better option than Equity.