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Module_6_Chapter_12.docx - St. Joe Trucking has sold anshowing page 1-3 out of 3

4. St. Joe Trucking has sold an issue of $6 cumulative preferred stock to the public at
a price of $60 per share. After issuance costs, St. Joe netted $57 per share. The
company has a marginal tax rate of 40 percent.
a.
Calculate the after-tax cost of this preferred stock offering assuming that
this stock is perpetuity.
Preferred Dividend per share = $6
Marginal tax rate = 40%
Cost of Preferred Stock = [Preferred Dividend / Stock value per
share] Cost of Preferred Stock (R
P
) = [D / P
0
]
D = Fixed Dividend
P
0
= Current price per share of the preferred stock
Cost of Preferred Stock = [$6 / $57]
Cost of Preferred Stock = 0.10526 (or0 10.52%
After-tax Cost of Preferred Stock = 10.52% (1-
40%) After-tax Cost of Preferred Stock = 0.1052
(0.60)
After-tax Cost of Preferred Stock =0.06312 (or)
6.312% After-tax
Cost of Preferred
Stock =
6.312%
b. If the stock is callable in 5 years at $66 per share and investors expect it to
be called at that time, what is the after-tax cost of this preferred stock offering?
(Compute to the nearest whole percent.)
Preferred stock callable in five years at $66 per share
Cost of Preferred Stock (R
P
) = [D / P
0
]
D = Fixed Dividend
P
0
= Current price per share of the preferred stock
Cost of Preferred Stock = [$6 / $66]
Cost of Preferred Stock = 0.0909 (or) 9.09%
Cost of Preferred Stock = 9.09%
After-tax Cost of Preferred Stock = 9.09% (1-
40%) After-tax Cost of Preferred Stock = 0.0909
(0.60)
After-tax Cost of Preferred Stock =0.05454 (or)
5.454% After-tax
Cost of Preferred
Stock =
5.454%
5. The stock of Alpha Tool sells for $10.25 per share. Its current dividend rate,
D
0, is $1
per share. Analysts and investors expect Alpha to increase its dividends at a
10 percent rate for each of the next 2 years. This annual dividend growth rate is expected
to decline to 8 percent for years 3 and 4 and then to settle down to 4 percent per year
forever. Calculate the cost of internal equity for Alpha Tool.
D1 = 1.10
D2= 1.21
D3=1.31
D4=1.41
D5=1.47
Value at the End of Year 4 = 1.47/(r-.04)
We know current price of stock is PV of all future cash inflows so,
10.25=1.10/(1+r) + 1.21/((1+r)^2) + 1.31//((1+r)^3) + 1.41//((1+r)^4) +{1.47/(r-.04)}/
(1+r)^4)
Solving for r = .1598 or 15.98%
6. The Hartley Hotel Corporation is planning a major expansion. Hartley is financed 100
percent with equity and intends to maintain this capital structure after the expansion.
Hartley
s beta is 0.9. The expected market return is 16 percent, and the risk-free rate is
10 percent. If the expansion is expected to produce an internal rate of return of 17
percent, should Hartley make the investment?
We have Rf = 10%, β = 0.9, rm =
16% ke = Rf + β (rm – rf)
= 10% + 0.9(16% - 10%)
= 15.4%
Because the IRR (17%) exceeds the cost of capital (15.4%), Hartley should invest in the
expansion.
8. The Ewing Distribution Company is planning a $100 million expansion of its chain of
discount service stations to several neighboring states. This expansion will be financed,
in part, with debt issued with a coupon interest rate of 15 percent. The bonds have a 10-
year maturity and a $1,000 face value, and they will be sold to net Ewing $990 after issue
costs. Ewing
s marginal tax rate is 40 percent. Preferred stock will cost Ewing 14 percent
after taxes. Ewing
s common stock pays a dividend of $2 per share. The current market
price per share is $15, and new shares can be sold to net $14 per share. Ewing
s
dividends are expected to increase at an annual rate of 5 percent for the foreseeable
future. Ewing expects to have $20 million of retained earnings available to finance the
expansion.
Ewing
s
target
capital
structure
is
as
follows:
Debt
20%
Preferred stock
5
Common equity
75
Calculate the weighted cost of capital that is appropriate to use in evaluating this
expansion program.
Cost of debt:
$990 =
k
d
= 6.9% by calculator
k
d
= 6.9% (1 - 0.4) = 4.1%
k
p
= 7.5%
k
e
.11or 11%
k
a
= 0.2(4.1%) + 0.05(7.5%) + 0.75(11%) = 9.4%