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Chapter 4: Q15BP (page 365)

The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 3 percent less than that for preferred stock. Based on the following facts, is she correct?

Debt can be issued at a yield of 11.0 percent, and the corporate tax rate is 20 percent. Preferred stock will be priced at \(60 and pay a dividend of \)6.40. The flotation cost on the preferred stock is $6.

Short Answer

Expert verified

Answer

Yes, Riley is correct. Cost of debt is 8.8%. Cost of preferred stock is 11.85%. There is approximately difference of 3 between them.

Step by step solution

01

 Introduction

The cost of preferred stock is similar to the cost of debt in that a constant annual payment is made, but dissimilar in that there is no maturity date on which a principal payment must be made.

02

 Calculation of cost of debt and cost of preferred stock


kd(Costofdebt)=Y(1-T)=11脳(1-20%)=11脳0.80=8.8%

Kp(CostofPreferredstock)=DpPp-F脳100=$6.40$60-$6脳100=11.85%

03

 Assumption of treasurer

The after-tax cost of debt is approximately 3.05 percent less than that for preferred stock. Based on the following facts, so her assumption of 3 person less is correct.

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Most popular questions from this chapter

Lance Whittingham IV specializes in buying deep discount bonds. These represent bonds that are trading at well below par value. He has his eye on a bond issued by the Leisure Time Corporation. The $1,000 par value bond pays 4 percent annual interest and has 18 years remaining to maturity. The current yield to maturity on similar bonds is 14 percent.

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Hooper Chemical Company, a major chemical firm that uses such raw materials as carbon and petroleum as part of its production process, is examining a plastics firm to add to its operations. Before the acquisition, the normal expected outcomes for the firm were as follows:

Outcomes (\( millions) Probability

Recession .............................. \)20 0.30

Normal economy ................... 40 0.40

Strong economy .................... 60 0.30

After the acquisition, the expected outcomes for the firm would be:

Outcomes (\( millions) Probability

Recession .............................. \) 10 0.3

Normal economy ................... 40 0.4

Strong economy .................... 80 0.3

a. Compute the expected value, standard deviation, and coefficient of variation before the acquisition.

b. After the acquisition, these values are as follows:

Expected value .............................................. 43.0 (\( millions)

Standard deviation ........................................ 27.2 (\) millions)

Coefficient of variation ................................... 0.633

Comment on whether this acquisition appears desirable to you.

c. Do you think the firm鈥檚 stock price is likely to go up as a result of this acquisition?

d. If the firm were interested in reducing its risk exposure, which of the following three industries would you advise it to consider for an acquisition?

Briefly comment on your answer.

(1) Chemical company

(2) Oil company

(3) Computer company
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