Question

1.....A firm is paying a 4% coupon interest rate for its outstanding bonds. All else constant, the higher the firm's tax rate: Select one: A. The higher its after-tax cost of debt B. The lower its after-tax cost of debt C. The after-tax cost of debt remains unchanged D. The answer cannot be determined with the information provided

2......Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for stone corp. given the following information:

Bond coupon rate 14%

Bond yield 10%

Dividend expected $5

Price common $100

Growth rate 8%

Corporate tax rate 30%

Select one:

A. 9.50%

B. 10.00%

C. 11.50%

D. 12.00%.

Answer 1

Answer 1)

After tax cost of Debt is calculated as follow : -

Cost of Debt * (1+ taxe rate)

So higher the Taxe rate, lower will be the cost of debt.

Option B is correct.

Answer 2)

After tax Cost of Debt is = 10%(1-0.30) = 7%

Value of Common Stock =

100 = 5 / (Rate of Return - 0.08)

100* Rate of Return - 100 * 0.08 = 5

100* Rate of Return - 8 = 5

Rate of Return = 5 + 8 / 100

Rate of Return = 13%

WACC =  (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 13% * 0.50 + 7% * 0.50

= 10%

Option B is correct.