Question

Adams Corporation's present capital structure, which is also its target capital structure is

40% debt and 60% common equity. Next year's net income after tax is projected to be
$21,000, and Adams' payout ratio is 30%. The company's earnings and dividends are
growing at a constant rate of 5%; the last dividend (D0) was $2.00; and the current
equilibrium stock price is $21.88. Adams can raise up to $20,000 of debt at a 12% before-
tax cost. All debt after $20,000 will cost 16%. If Adams issues new common stock, a 20%
flotation cost will be incurred. The firm's marginal tax rate is 34%.
a/ What is the maximum amount of new capital that can be raised at the LOWEST
component cost of EQUITY?
b/ What is the component cost of equity by selling new common stock?
thanks

Answer 1

Task a:

The answer is $24,500.

Task b:

The answer is 17%

Step-by-step explanation:

Task a:

What is the maximum amount of new capital that can be raised at the LOWEST component cost of EQUITY?

Solution:

We already know the following:

Projected net income = $21,000

Payout ratio = 30%

Retention ratio = 70%

Debt share = 40%

Equity share = 60%

Maximum amount of capital to be raised at the lowest component cost of equity = Projected net income ×
`(Retention ratio)/(Equity share)`

= $21,000 ×
`(0.70)/(0.60)`

= $24,500

Answer:

The maximum amount of new capital that can be raised at the lowest component of equity is $24,500.

Task b:

What is the component cost of equity by selling new common stock?

Solution:

k(e) (component cost of external equity) = [Dividend (D0)(1 + growth) / stock price(1 - flotation cost)] + growth

Formula:

k(e) =
`(Do(1+g))/(P(1-0.20))` + 0.05

Where

Do = $2.00

G = 0.05

P = $21/88

= ($2.00(1 + 0.05) / $21.88(1-.20)) + 0.05

= ($2.10/$21.88(1-.20)) + 0.05

= ($2.10/$21.88(0.80) + 0.05

= 0.17 or 17%

Answer:

The component cost of equity by selling new common stock = 17%