The Allied Group intends to expand the company's operation
The Allied Group intends to expand the company's operation by making significant investments in several opportunities available to the group. Accordingly, the group has identified a need for additional financing in preferred and new common stock and new bond issues. The (Krf) risk-free rate for the company is 7%, and the appropriate tax rate is 40%. Also, the beta coefficient for the company is 1.3 and the market risk premium (Km) is 12%.
New Debt (Kd)
The company has been advised that new bonds can be sold on the market at par ($1000) with an annual coupon of 8%, for 30 years.
New Common Stock
Market analysis has determined that given the positive history of the firm, new common stock can be sold at $29 per share, with the last dividend being paid of $2.25 per share. The growth rate on any new common stock has been estimated at a constant rate of 15% per year for the next 3 years.
Preferred Stock
New Preferred Stock can be issued with an annual dividend of 10% of par and is paid annually and currently, would sell for $90 per share.
Tasks:
Using the Capital Asset Pricing Model (CAPM), discuss and calculate the cost of new common stock (Ks).
What would the dividend yield as a percentage (i.e., per dividend payment divided by the book value of a share of stock) today and a year from now if the dividend growth rate is 12%?
What is the after-tax cost as a percentage (e.g., interest rate) of new debt today?
What are your recommendations for raising capital based on your answers to the above questions plus considering other factors (e.g., current and potential changes in the economy locally, regionally, nationally, and worldwide, changes in the demand and/or supply plus cost of materials, skilled labor, management and/or leadership, changes in interest, tax, inflation and/or supply of investment capital)?
Sample Solution
Cost of New Common Stock (Ks): The cost of new common stock can be calculated using the Capital Asset Pricing Model (CAPM). The formula for this is Ks = Krf + β(Km - Krf), or Ks = 7% + 1.3(12%-7%) = 14.1%.
Dividend Yield:
Today: The dividend yield is given by D/P, where D is the current dividend and P is the book value per share. In this case, it would be 2.25/29 = 0.0776 or 7.76%.
A Year From Now: Using the constant growth rate of 12%, we can calculate the expected dividend one year from now as D1=D0*(1+g) where g is the growth rate, and in this case equals 12%. Therefore, D1=2.25*(1+12%)=2.52475 which gives a dividend yield of 8.66% with a book value per share remaining at $29 (i.e., 2.52475/29).
After-Tax Cost Of New Debt:
The after-tax cost of new debt can be calculated using the formula R=(Coupon Rate * (1-T))/(Par Value) where T is equal to 40%, or 0.4 in decimal form, to represent the tax rate and Coupon Rate is 8% in this case since that was given above as being what these bonds will pay out annually if they are sold at par ($1000). This yields an after-tax cost of new debt today as 4.8%.
Recommendations For Raising Capital:
Given all factors considered plus my prior calculations on each approach to raising capital, I recommend choosing a combination strategy that takes advantage of both preferred stock and new common stock issuance along with some additional debt financing for optimal results according to your individual risk tolerance level and personal goals for returns on investment for shareholders over time.. Preferred stocks have greater safety than common stocks because their dividends are usually set ahead of time so investors know exactly how much income they will receive annually whereas common stocks may change based on company performance but offer potentially higher returns due to their underlying upside potential when it comes to appreciation in price over time especially if you choose ones with high quality management teams in place who make smart decisions while running operations well within budget expectations most often consistently meeting financial projections along with other important considerations such as customer satisfaction rates continuingly increasing yearly etcetera thus resulting in strong overall performance across multiple metrics generally leading into increased shareholder value creation opportunities going forward into future years downline hence why I believe adding them alongside preferred shares plus some debtholding here too makes sense strategically