1. Algeria Corporation may raise new capital in one of the following three ways.

Question

1. Algeria Corporation may raise new capital in one of the following three ways. It has tax rate of 33%. Find the after-tax cost of new capital.

(A) It can sell common stock at $29 a share, which will pay a dividend of $2.30 next year. The expected rate of growth of dividends is 4% per annum forever. answer is 11.93%

(B) It can sell 8% bonds at $860 each, which will mature in 10 years. Assume that the bonds pay interest twice a year and the company pays taxes once a year. answer is Approximately, 6.772%, exactly, 6.984%

(C) By selling $5 preferred stock at $45 a share, redeemable at par after 5 years. answer is 11.11%

2. Benin Company has the following capital structure: 5.5 million shares of stock, selling at $26 each, with beta = 1.2; zero-coupon bonds with face amount $70 million, maturing in 12 years, with yield to maturity 7.4%; and 400,000 shares of preferred stock selling at $13 per share, paying a dividend of 32% per quarter. The income tax rate of Benin is 31%. The risk-free rate is 4.5%, and the expected return on the market 12%. Do not use the original issue discount. Find the weighted average cost of capital for Benin.

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Explanation / Answer

1. Algeria Corporation may raise new capital in one of the following three ways. It has tax rate of 33%. Find the after-tax cost of new capital.

(A)

Price of share = D1/(r-g)

29 = 2.3/(r-4%)

r-4% = 2.3/29

r = 2.3/29 +4%

cost of new capital, r= 11.93%

(B) It can sell 8% bonds at $860 each, which will mature in 10 years. Assume that the bonds pay interest twice a year and the company pays taxes once a year. answer is Approximately, 6.772%, exactly, 6.984%

Coupon payment = 8%*1000/2= 40

Present value of all future payments = $860

Let cost of capital be r

Number of payments = 10*2 = 20

860 = 40/(1+r/2) + 40/(1+r/2)^2 + 40/(1+r/2)^3 + 40/(1+r/2)^4 ....... 40/(1+r/2)^20 + 1000/(1+r/2)^20

r= 10.27%

After tax cost of capital = 10.27%*(1-33%) = 6.9%

(C) By selling $5 preferred stock at $45 a share, redeemable at par after 5 years. answer is 11.11%

45 = 5/(1+r) + 5/(1+r)^2 + 5/(1+r)^3 + 5/(1+r)^4 + 5/(1+r)^5 + 45/(1+r)^5

Using IRR function in excel

r= 11.11%

2.

Market value of equity = 5.5*26 = 143 million

re = 4.5% + 1.2*(12%-4.5%)= 13.5%

Market value of debt = 70/(1+7.4%)^12= 29.72 million

Market valu of preferred stock = 400000*13= 5.2 million

Let cost of preferre stock = rp

dividend = 32%*1 = 0.32

13 = 0.32/(rp/4)

rp= 9.85%

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