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Homework answers / question archive / 1) Shaggy Dog Corp has established a target capital structure of 40% debt and 60% common equity
1) Shaggy Dog Corp has established a target capital structure of 40% debt and 60% common
equity. The firm expects to earn $600 in after-tax income during the coming year, and to retain 40% of those earnings. The current market price of the firm's stock is $28; its last dividend was D0 = $2.20, and its expected growth rate is 6 percent. Shaggy Dog can issue new common stock at a 15% flotation cost. What will Shaggy's marginal cost of equity capital be if it must fund a capital budget requiring $600 in total new capital?
2) Suppose a firm has a bond issue currently outstanding that has 27 years left to maturity. The coupon rate is 7.25% and coupons are paid semi-annually. The bond is currently selling for $975 per $1,000 bond. The firm faces a 40% tax rate. What is the firm's after tax cost of debt?
1) Computation of the marginal cost of equity:-
D1 = D0*(1+Growth rate)
= $2.20*(1+6%)
= $2.33
Cost of equity = (D1 / (Current stock price * (1 - Flotation cost)) + Growth rate
= ($2.33 / ($28 * (1 - 15%)) + 6%
= ($2.33 / $23.80) + 6%
= 9.80% + 6%
= 15.80%
2) We can calculate the cost of debt by using the following formula in excel:-
=rate(nper,pmt,-pv,fv)
Here,
Rate = Cost of debt (Semiannual)
Nper = 27*2 = 54 periods (semiannual)
Pmt = Coupon payment = $1,000*7.25%/2 = $36.25
PV = $975
FV = $1,000
Substituting the values in formula:
= rate(54,36.25,-975,1000)
= 3.73%
Cost of debt = Rate * 2
= 3.73% * 2
= 7.47%
After tax cost of debt = Cost of debt*(1-Tax rate)
= 7.47%*(1-40%)
= 4.48%
