Table 9.1
A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of
2 percent of the face value would be required in addition to the discount of $40.
Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent.
-The firm's before-tax cost of debt is ________. (See Table 9.1)
A) 7.8 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent

Question

Table 9.1
A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions.  Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of
2 percent of the face value would be required in addition to the discount of $40.
Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent.
-The firm's before-tax cost of debt is ________. (See Table 9.1)
A) 7.8 percent 
B) 10.6 percent 
C) 11.2 percent 
D) 12.7 percent

Quizplus · Accepted Answer

To calculate the before-tax cost of debt, we need to use the following formula:
Before-tax cost of debt = (annual interest payment ÷ net proceeds) + flotation costs
Annual interest payment = Face value * Coupon rate = $1,000 * 7% = $70
Net proceeds = Selling price - Flotation costs - Face value = $960 - ($1,000 * 2%) - $1,000 = $920
Flotation costs = $40
Before-tax cost of debt = ($70 ÷ $920) + 2% = 7.8%

Table 9.1 A Firm Has Determined Its Optimal Capital Structure Which Is