A firm has determined its optimal structure which is composed of the following sources and target market value proportions
$$\begin{array} { l c }
\text { Source of capital } & \begin{array} { c }
\text { Target market } \
\text { Proportions }
\end{array} \
\hline \text { Long-term debt } & 60 \% \
\text { Common stock equity } & 40
\end{array}$$
DEBT: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
COMMON STOCK: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent.

-The firm's aftertax cost of debt is
A) 7.7 percent.
B) 7 percent.
C) 4.7 percent.
D) 6 percent.

Question

A firm has determined its optimal structure which is composed of the following sources and target market value proportions
$$\begin{array} { l c } 
\text { Source of capital } & \begin{array} { c } 
\text { Target market } \
\text { Proportions }
\end{array} \
\hline \text { Long-term debt } & 60 \% \
\text { Common stock equity } & 40
\end{array}$$
DEBT:  The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050.  A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
COMMON STOCK:  A firm's common stock is currently selling for $75 per share.  The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years.  Five years ago, the dividend was $3.10.  It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.  Additionally, the firm has a marginal tax rate of 40 percent.

-The firm's aftertax cost of debt is
A) 7.7 percent.
B) 7 percent.
C) 4.7 percent.
D) 6 percent.

Quizplus · Accepted Answer

The after-tax cost of debt is calculated using the formula: $ \text{After-tax cost of debt} = \text{Coupon rate} \times (1 - \text{Tax rate}) $. The coupon rate is 8%, and the tax rate is 40%, so the after-tax cost of debt is $ 8\% \times (1 - 0.40) = 4.8\% $. However, considering the bond is sold at a premium and flotation costs, the effective cost is slightly lower, approximately 4.7%.

A Firm Has Determined Its Optimal Structure Which Is Composed