Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas if it goes through with the debt issuance?
Annual Interest tax shield = (Interest * tax)
Interest = $(7/100 * 20,000,000)
= $1.4 million
Tax Shield = 40/100
= 0.4
Annual Interest tax shield = (1.40 million * 0.40)
= $ .56 million or $560,000
2. Carbon8 Corporation wants to raise $120 million in a seasoned equity offering, net of all fees. Carbon8 stock currently sells for $28.00 per share. The underwriters will require a fee of $1.25 per share and indicate that the issue must be underpriced by 7.5%. In addition to the underwriter’s fee, the firm will incur $785,000 in legal, administrative, and other costs. How many shares must Carbon8 sell to raise the desired amount of capital?
Required Net of all fees = $120 Million
Legal, administrative, and other costs = $785000
Issue Price = 28 – 7.5%*28 = $25.90
Underwriter Fee per share = 1.25
Net issue price after Underwriter Fee = 25.90 – 1.25 = 24.65
No of Share Carbon8 must sell in order to raise the desired amount of capital = (Required Net of all fees + legal, administrative, and other costs)/Net issue price after Underwriter Fee
No of Share Carbon8 must sell in order to raise the desired amount of capital = (120000000+785000)/24.65
No of Share Carbon8 must sell in order to raise the desired amount of capital = 4,900,000
3. FM Foods is evaluating its cost of capital. Use the following information provided on December 31, 2017, to estimate FM’s after-tax cost of equity capital.
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- Yield to maturity on long-term government bonds: 4.4%
- Yield to maturity on company long-term bonds: 6.3%
- Coupon rate on company long-term bonds: 7%
- Historical excess return on common stocks: 6.5%
- Company equity beta: 1.20
- Stock price: $40.00
- Number of shares outstanding (millions): 240
- Book value of equity (millions): $5,240
- Book value of interest-bearing debt (millions): $1,250
- Tax rate: 35.0%
Utilizing the market prices of equity and debt for weight computation. However, market value is not provided for debt, thus it is assumed that debt is trading at par, meaning market value = book value.
Cost of capital = (weight of equity * cost of equity) + (weight of debt * cost of debt after taxes)
Market equity value = number of shares * share price = 240 * 40 = $9,600,000,000
Market debt value = Book value of debt =1250 million
Equity weight = Mkt Equity Val/Total capital = 9600/10850 = 88.48 percent
Weight of debt = Mkt Equity Val / Total capital = $1,250 / $10,850 = 11.52 %
= Cost of equity = risk-free rate plus beta times the market risk premium
Risk free rate=yield on government bonds, which are the safest investments, hence risk free = 4.4%
Market risk premium=excess returns on stocks = 6.5 %
Equity cost = 4.4% + (1.2% * 6.5%) = 12.20%
= Cost of debt after taxes = Yield to maturity on bonds*
(1-tax rate) =6.3 percent *(1-35 percent) =4.095 percent
Cost of capital = (88.48 percent *12.20 percent) + (11.52 percent *4.095 percent) = 11.27 percent
Consequently, cost of capital equals 11.27%
