Financial Management

QUESTION

The following balance sheet extract relates to the Allied Insurance Company Bonds Payable $1,000,000 Preferred Stock $2,000,000 Common Stock $3,000,000 Additional Information: 1. The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 90% of par. 2. The companys common shares which have a book value of $25 per share are currently selling at $20 per share. 3. The preferred shares are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share. 4. The company has an equity beta of 1.35 and the current Treasury bill rate is 3.0%. The market risk premium is 1.5% 5. The companys tax rate is 30%. A. Calculate Allieds cost of debt. B. Calculate Allieds cost of equity. C. Calculate Allieds cost of preferred shares D. Estimate Allieds market value weighted average cost of capital. E. Explain why the cost of debt is cheaper than the cost of equity.
a. Cost of debt (Kd) = Coupon rate x (1-tax rate) = 8% x (1 0.30) = 5.6% b. Cost of equity (Ke) = Risk-free rate of return + (Equity Beta x Market risk premium) Ke = 3% + (1.35 x 1.5%) = 3% + 2.025% = 5.025% c. Cost of preference shares (Kp) = Dividend on preferred stock / Current price of preference shares Kp = ($100 x 5%) / $80 = $5 / $80 = 6.25% d. The market value weighted average cost of capital is 5.531% Capital structure Market value Ratio Cost of capital Weighted average cost of capital (WACC) Debt

00,000 x 90%) $9,00,000 18.37% 5.600% 1.029% Preference shares ($2,000,000 x 80%) $16,00,000 32.65% 6.250% 2.041% Equity shares ($3,000,000 x $20 / $25) $24,00,000 48.98% 5.025% 2.461% $49,00,000 100.00% 5.531% e. The cost of debt is cheaper than cost of equity as the debt component has tax savings, which is not available in the cost of equity.

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