## 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%