Question

1. A firm is considering selling $20 million worth of 30-year, 10% coupon bonds with a par value of $1,000. Because bonds with similar risk earn return greater than 10%, the firm must sell the bonds for $990 to compensate for the lower coupon interest rate. The flotation costs are 3% of par. Calculate the before-tax cost of debt.

2. Using the scenario in part Question #1, calculate the after-tax cost of debt if the firm’s tax rate is 40%

3. A firm is contemplating an issuance of a 10% preferred stock that they expect to sell for $78 per share. The cost of issuing and selling the stock will be $3 per share. Calculate the after-tax cost of the preferred stock if the firm’s tax rate is 35%.

4. A firm paid out dividends in 2007 in the amount of $2.97 on the outstanding shares of common stock. More recently in 2012, the firm paid out dividends of $3.80. Calculate the growth rate on these shares of stock, assuming that the applicable tax rate is 40%.

Answer 1

1: Using financial calculator

Input: FV = 1000

N = 30

PMT = 10%*1000 = 100

PV = Price after flotation = -990*(1-0.03)

=-960.30

Solve for I/Y as 10.44%

Hence before tax cost of debt = 10.44%

2: After tax cost of debt = YTM*(1-Tax)

= 10.44%*(1-0.4)

= 6.26%

3: After tax cost of preferred stock = Dividend/ Price after flotation

= 10%*100/(78-3)

=13.33%

(There is no tax impact since dividends are not tax deductible)

4: Using financial calculator

Input: Fv = 3.8

PV = -2.97

N= 5

Solve for I/Y as 5.05%

Hence the growth rate is 5.05%