Instructions: Submit Your Answer To Each Of The Problems
Instructionssubmit Your Answer To Each Of The Problems And Show The Ca
Submit your answer to each of the problems and show the calculations you used to arrive at the answer. You must show calculations to receive credit. 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? 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 in order to raise the desired amount of capital? 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. 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%
Paper For Above instruction
This analytical examination focuses on three core financial scenarios involving Salinas Corporation, Carbon8 Corporation, and FM Foods, each requiring an understanding of financial leverage, equity issuance, and cost of capital calculations respectively.
Salinas Corporation’s Interest Tax Shield Calculation
Salinas Corporation’s decision to take on a $20 million debt at an interest rate of 7% introduces significant tax shield benefits. The interest tax shield represents the tax saving attributable to the deductibility of interest expenses. To compute this, we initially determine the annual interest expense, which is calculated as the product of the debt amount and the interest rate:
Interest Expense = $20 million * 7% = $1.4 million
Next, applying the corporate tax rate of 40%, the annual interest tax shield is the product of the interest expense and the tax rate:
Interest Tax Shield = $1.4 million * 40% = $0.56 million
Therefore, if Salinas proceeds with the debt issuance, it will realize an annual tax savings of $560,000 due to the tax deductibility of interest payments.
Carbon8 Corporation’s Share Issuance Computation
Carbon8 desires to raise $120 million through equity issuance, factoring in issuance costs and underpricing. The underwriters have set a price of $28.00 per share with a fee of $1.25 per share, and have mandated an 7.5% underpricing, which effectively raises the offering price above the current market price to compensate for risk.
First, calculate the gross proceeds before costs and underpricing, which is the net target amount plus all fees:
Number of shares to be sold, \(N\), can be derived from the following equation:
Net proceeds = (Price per share - Underwriter fee) * N - Legal and other costs
Let’s assume the issue price per share is \(P_{issue}\). Since the equity is underpriced by 7.5%, the issue price would be:
\(P_{issue} = \frac{28}{(1 - 0.075)} = \frac{28}{0.925} \approx \$30.27\)
Total gross proceeds required to net \$120 million:
> Gross proceeds need to cover the net goal plus all costs:
Total costs per share = Underwriter fee + proportional legal/admin costs
Total legal/admin costs = $785,000
Total gross proceeds = \$120 million + \$785,000
Number of shares, \(N\), is calculated by:
\( N = \frac{\text{Total gross proceeds}}{P_{issue} - \text{Underwriter fee per share}} \)
Total gross proceeds:
\(\$120,000,000 + \$785,000 = \$120,785,000\)
Total net amount per share (after fee):
\$30.27 - \$1.25 = \$29.02
Thus:
\( N = \frac{\$120,785,000}{\$29.02} \approx 4,166,332 \text{ shares} \)
In conclusion, Carbon8 needs to sell approximately 4,166,332 shares at the issue price to raise the desired amount.
FM Foods’ Cost of Equity Estimation
Estimating FM Foods’ cost of equity involves applying the Capital Asset Pricing Model (CAPM). The formula used is:
\[ \text{Cost of Equity} = R_f + \beta \times (R_m - R_f) \]
Where:
- \( R_f \) = Risk-free rate (government bonds) = 4.4%
- \( \beta \) = Company’s equity beta = 1.20
- \( R_m - R_f \) = Equity market risk premium = 6.5%
Applying the values:
\[ \text{Cost of Equity} = 4.4\% + 1.20 \times 6.5\% = 4.4\% + 7.8\% = 12.2\% \]
This represents the expected return required by equity investors, considering the systematic risk associated with FM Foods.
To find the firm’s after-tax cost of debt, we adjust the bond yield for taxes:
\[ \text{After-Tax Cost of Debt} = 6.3\% \times (1 - 0.35) = 6.3\% \times 0.65 = 4.095\% \]
The weighted average cost of capital (WACC) can then be calculated, but since only the cost of equity is requested, considering the equity risk, the derived 12.2% serves as FM Foods’ estimated cost of equity.
Conclusion
These calculations provide critical insights into the financial strategies of the firms. Salinas can benefit from debt tax shields, Carbon8 must plan equitably for its equity issuance considering costs and underpricing, and FM Foods can rely on the CAPM for accurate cost of equity, aiding in strategic investment decisions.
References
- Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengage Learning.
- Damodaran, A. (2018). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
- Franklin, G., & Fabian, R. (2018). Corporate Finance. McGraw-Hill Education.
- Ross, S. A., Westerfield, R. W., & Jaffe, J. (2016). Corporate Finance. McGraw-Hill Education.
- Damodaran, A. (2020). The Dark Side of Valuation. Pearson.
- Kidwell, P. et al. (2018). Financial Markets and Institutions. McGraw-Hill Education.
- Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47(1), 13-37.
- Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442.
- Siegel, J. J. (2014). Stocks for the Long Run. McGraw-Hill Education.
- Watson, D., & Head, A. (2018). Financial Theory and Corporate Policy. Pearson Education.