Question

a. XYZ Company is undergoing a major expansion. The expansion will be financed by issuing new 16-year, $1,000 par, 8% annual coupon bonds. The market price of the bonds is $1,020 each. Flotation expense on the new bonds will be $60 per bond. The marginal tax rate is 35%. What is the post-tax cost of debt for the newly-issued bonds?

b. ABC Corporation will issue new common stock to finance an expansion. The existing common stock just paid a $1.25 dividend, and dividends are expected to grow at a constant rate of 9% indefinitely. The stock sells for $48, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of new commonstock?

Answer 1

a) We have to calculate first the yield to maturity of the bond using the formula.

Where C =annual coupon rate 8%

Floatation cost is 60$per bond

Cost of debt is C/P*(1-T)

Where C =annual interest payment

P=net proceeds

T=tax rate

As floation cost is involved a bond of face value 1000with coupon 8% and floation 60$per bond will cost around 1020$

So cost of debt according to formula is 5.10%

b)The formula is D/P*(1-F) + g

Where D =dividend

P=current stock price

F=floation expense in percentage

g=growth rate

According to the formula cost of equity will be 11.74%

n=maturity=16 yrs

M=Face value + Coupon=1020$

Face value=1000$