Posted: April 26th, 2016
Hints for completing the harder questions:
Problem 31 is a challenging problem that will call on all of your analytical skills.
Remember that this perpetual bond is treated as debt for tax purposes. That means that the cost, kp, will be net of the tax considerations (1 – t), just like interest payments are. If you are unsure of how a perpetual bond works, check Campbell R. Harvey’s Hypertextual Finance Glossary at:
Problem 32 is most easily solved by setting up a table, as you did with the Fizz and Eddy cost of capital calculations.
1. You must calculate the rate of growth > g over 5 years for the common stock based on $.80/$1.23 = ? Look up ? in Appendix B at the back of your textbook on page 720 (find value of i next to n = 5) to find the % to use for g in your formula.
2. The cost of debt can be more easily calculated using Formula 11-1b from your textbook: Kd = Y(1 – T)/(1 – F)
Please note that you must use market values when determining weightings for calculating the weighted average cost of capital (WACC).
—- Questions I need help with
31. Island Capital has the following capital structure:
The existing bonds have a coupon rate of 8 percent with 18 years left to maturity, but current yields on these bonds are 11 percent. Flotation costs are $25 per $1,000 bond would be expected on a new issue.
The existing perpetuals have a $25 par value and an annual dividend rate of 9 percent. New perpetuals could be issued at $50 par value with an 8 percent yield. Flotation costs would be 3 percent. There are 4 million common shares outstanding that currently trade at $18 per share and expect to pay a dividend next year of $1.75 that will continue to grow at 7 percent per annum for the foreseeable future. New shares could be issue at $17.50 and would require flotation expenses of 5 percent of proceeds.
Island’s tax rate is 39 percent, and it is expected that internally generated funds will be sufficient to fund capital projects in the near future.
a. Compute Island Capital’s current cost of capital with market value weightings.
b. How would the cost of capital calculation change if new shares are required to fund the equity component of the capital structure?
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