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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

What factors might influence a firm鈥檚 price-earnings ratio?

What approaches can be taken in valuing a firm鈥檚 stock when there is no cash dividend payment?

Home Security Systems is analyzing the purchase of manufacturing equipment that will cost \(50,000. The annual cash inflows for the next three years will be:

Year

Cash flow

1

\)25,000

2

23,000

3

18,000

a. Determine the internal rate of return.

b. With a cost of capital of 18 percent, should the machine be purchased?

How much would you have to invest today to receive a. $15,000 in 8 years at 10 percent?

Keller Construction is considering two new investments. Project E calls for the purchase of earthmoving equipment. Project H represents an investment in a hydraulic lift. Keller wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project E (\(20,000 Investment)

Year

Cash flows

1

\)5,000

2

6,000

3

7,000

4

10,000

Project H (\(20,000 Investment)

Year

Cash flows

1

\)16,000

2

5,000

3

4,000

  1. Determine the net present value of the projects based on a zero percent discount rate.

  2. Determine the net present value of the projects based on a 9 percent discount rate.

  3. The internal rate of return on Project E is 13.25 percent, and the internal rate of return on Project H is 16.30 percent. Graph a net present value profile for the two investments similar to Figure12-3. (Use a scale up to \(8,000 on the vertical axis, with \)2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

  4. If the two projects are not mutually exclusive, what would your acceptance or rejection decision be if the cost of capital (discount rate) is 8 percent? (Use the net present value profile for your decision; no actual numbers are necessary.)

  5. If the two projects are mutually exclusive (the selection of one precludes the selection of the other), what would be your decision if the cost of capital is (1) 6 percent, (2) 13 percent, (3) 18 percent? Once again, use the net present value profile for your answer.
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