Question

Please show all work.

FINA Inc. considers a project with the following information:

Initial Outlay: 1,500

After-tax cash flows:

Year 1: -$100

Year 2: $1000

Year 3: $700

FINA’s assets are $500 million, financed through bank loans, bonds, preferred stocks, and common stocks. The amounts are as follows: Bank loans: $ 100 million borrowed at 10% Bonds: $180 million, paying 9% coupon with quarterly payments, and maturity of 5 years. FINA sold its $1,000 par-value bonds for $1,070 and had to incur $20 flotation cost per bond. Preferred Stocks: $20 million, paying $15 dividends per share. FINA sold its preferred shares for $210 and had to incur a $10/share flotation cost. Common Stocks: $200 million, the beta of FINA stocks is 1.5, the 90 day Treasury yield is 5%, and the return on the market portfolio is 15 %. FINA is subject to a 20% tax rate. Assuming the company uses WACC to compute the present value of the future cash flows, please find the following:

1) What is the after-tax cost of the loans?

2) What is the after-tax cost of the bonds?

3) What is the after-tax cost of preferred stock?

4) What is the after-tax cost of common stock?

Answer 1

1) Calculation of the after tax cost of loan :-

After Tax cost of loan= interest rate * ( 1- tax rate)

= 10% * ( 1 - 0.20 ) = 8%

2)

Calculation of the after tax cost of bonds :-

cost of bonds before tax = [ i + ( D - NP) / n ] / ( D + NP)/2

Here I = annual interest payment = 1000 *9% = 90

D = Face value =1000

NP = Net proceeds - flotation cost= 1070 - 20 = 1050

=[ 90 + ( 1000 - 1050) / 5] / ( 1000 + 1050) /2

= [ 90 -10] / 1025 = 0.078049

cost of bonds after tax = 0.078049 * ( 1 - 0.20) = 6.24%

3) Calculation of After tax cost of preferred stock :-

After tax cost of preferred stock = Dividend / (market price - flotation cost)

= 15 / (210 -10)= 7.5%

4) Calculation of After tax cost of equity :-

Cost of equity using capm = Rf + Beta ( Rm - Rf)

Rf = risk free return = 5%

Rm= market return = 15%

Beta = 1.5

= 5% + 1.5 ( 15% - 5%)

cost of equity after tax = 20%