(a) Your boss tells you that the company is undertaking a $100 million pollution
ID: 2817151 • Letter: #
Question
(a) Your boss tells you that the company is undertaking a $100 million pollution abatement project. She says that there are three sources of funds that are being considered: (1) Sell ordinary debt with a 10% coupon. (2) Sell "pollution control bonds" with a 6% coupon (the interest is tax exempt). (3) Sell common stock with a current dividend yield of 4%. Your boss says that one of the directors suggests equity, since it carries the lowest rate among the alternatives. What do you say?
(b) Another director argues that debt has a tax advantage over equity and that the interest tax shield from the ordinary bond will be greater than that of the pollution control bond. What do you say?
Explanation / Answer
Cost of equity is not just dividend yield it is dividend yield*(1+growth rate)+growth rate..We will see that equity will have highest cost hence the director is incorrect because the dividend is not gojng to be constant in the future.
Interest paid will be higher for 10% and hence higher interest will be tax exempt..SO 10% bond will have higher interest tax shield..THe director is correct.
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