1. XYZ company is undergoing a major expansion. The expansion will be financed b
ID: 2784382 • Letter: 1
Question
1. XYZ company is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be S50 per bond. The marginal tax rate is 35%. What is the post-tax cost ofdebt for the newly-issued bonds? 2. ABC Corporation will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for S45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of new common stock? 3. XYZ Inc will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of internal equity?Explanation / Answer
i)
We will use after-tax cost of debt because of interest providing a tax shield.
ii)
The dividend growth is expected to continue at the same rate forever and is effective from next year onwards. Flotation expenses will also need to be considered given they raise the cost of equity. We will use constant growth model but the appropriateness of the model is contingent on the assumption of constant growth. We assume there will not be further issuance of debt and equity because issuing either will raise the cost of equity and debt. The market is also taking the same growth rate and hence the price refelctes the growth rate
iii) For internal equity, floatation expenses will not be considered given we are calclauting the cost for exisiting shareholders. We will use constant growth model but the appropriateness of the model is contingent on the assumption of constant growth. The dividend growth is expected to continue at the same rate forever and is effective from next year onwards. The market is also taking the same growth rate and hence the price refelctes the growth rate
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