Instructions: The Allied Group Intends To Expand The Company

Instructionsthe Allied Group Intends To Expand The Companys Operation

The Allied Group plans to expand its operations by securing additional financing through issuing preferred stock, new common stock, and bonds. The company’s financial environment includes a risk-free rate of 7%, a corporate tax rate of 40%, a beta coefficient of 1.3, and a market risk premium of 12%. The new bonds will be issued at par value of $1,000 with an 8% annual coupon rate, maturing in 30 years. The new common stock can be sold at $29 per share, with the last dividend paid at $2.25 per share, and is expected to grow annually at 15% for the next three years. Preferred stock can be issued with a 10% annual dividend based on par value, currently selling at $90 per share. The assignment involves calculating the cost of new common stock (Ks) using CAPM, determining the current and projected dividend yields, calculating the after-tax cost of debt, and providing strategic recommendations based on these calculations and the broader economic context.

Paper For Above instruction

The process of company expansion necessitates strategic financial planning, especially concerning the various sources of capital—equity and debt—that a firm can tap into. The Allied Group's plans to issue preferred stock, common stock, and bonds are crucial decisions that involve assessing the costs of each source to optimize the capital structure and ensure sustainable growth. This paper explores the relevant calculations and financial considerations, primarily focusing on the cost of new common stock through the Capital Asset Pricing Model (CAPM), the dividend yield calculations, and the after-tax cost of new debt. Additionally, strategic recommendations are provided considering current economic factors that influence these financial decisions.

Cost of New Common Stock (Ks) Using CAPM

The CAPM provides a straightforward method for estimating the required rate of return for equity holders, reflecting the risk associated with the stock relative to the market. It is given by the formula:

Ks = Krf + β × (Km - Krf)

Where:

• KrF (Risk-free rate) = 7%, or 0.07
• β (Beta) coefficient = 1.3
• Km (Market risk premium) = 12%, or 0.12

Substituting the values, we get:

Ks = 0.07 + 1.3 × 0.12 = 0.07 + 0.156 = 0.226 or 22.6%

Therefore, the cost of new common stock (Ks) based on CAPM is approximately 22.6%.

Dividend Yield Calculation - Today and One Year from Now

Dividends are an essential indicator of company performance and investor return expectations. The current dividend (D0) is $2.25, and the dividend growth rate (g) is estimated at 15% annually for the next three years. The dividend yield today (DY0) and after one year (DY1) can be calculated as:

• Today’s dividend yield:

DY0 = D0 / Price per Share = 2.25 / 29 ≈ 7.76%

• Dividend next year (D1):

D1 = D0 × (1 + g) = 2.25 × 1.15 = 2.5875

• Projected dividend yield after one year (DY1):

DY1 = D1 / Price per Share (assuming the stock price grows at the same rate as dividends)

First, estimate the stock price one year from now, given the growth rate:

Price in one year (P1) = Price today × (1 + g) = 29 × 1.15 ≈ 33.35

Thus, DY1 = 2.5875 / 33.35 ≈ 7.76%

Note that if the stock price is expected to appreciate at the same rate as dividends, the dividend yield remains approximately the same at around 7.76%. This aligns with the assumption of constant growth in dividends and stock price.

After-Tax Cost of New Debt

The company can issue bonds at par with an 8% coupon rate. The before-tax cost of debt (Kd) is simply the coupon rate since bonds are issued at par, which is 8%. To compute the after-tax cost of debt, the tax shield provided by interest payments must be considered:

After-tax Kd = Kd × (1 - Tax Rate) = 0.08 × (1 - 0.40) = 0.08 × 0.60 = 0.048 or 4.8%

Thus, the effective after-tax cost of new debt is approximately 4.8%, making debt a relatively inexpensive source of capital due to tax advantages.

Strategic Recommendations for Raising Capital

Evaluating the above calculations and the current economic landscape, the Allied Group should consider a balanced approach to financing. The relatively low after-tax cost of debt (4.8%) suggests that debt financing remains an attractive option, especially if the company’s credit rating is strong and interest rates remain stable or decline. However, reliance on debt increases financial leverage and risk, particularly amid potential economic downturns or rising interest rates.

In contrast, the cost of equity (22.6%) is significantly higher, reflecting investor risk premiums and expected returns. While equity issuance dilutes ownership, it does not impose fixed obligations like debt. The projected dividend yields of around 7.76% indicate a reasonable return for investors, but the high cost of equity implies that funding via stock will be expensive initially. Nevertheless, it can be favorable if the company’s growth prospects are strong, which is suggested by the high dividend growth rate (15%).

Given the current economic outlook—including potential inflationary pressures, regional and national economic fluctuations, and global uncertainties—the company should also consider market conditions. If market interest rates rise or investor risk appetite diminishes, the cost of issuing equity and debt could increase. Moreover, supply chain disruptions and labor shortages might escalate costs, impacting profitability and the ability to service new debt or attract equity investors.

Therefore, a prudent capital structure would involve utilizing debt primarily for its tax advantages while strategically issuing equity to support long-term growth and maintain financial flexibility. The company should also explore alternative financing avenues, such as convertible bonds or mezzanine financing, to optimize its capital costs.

In conclusion, based on the calculations and economic considerations, the recommended strategy for the Allied Group is to leverage the low-cost debt while cautiously proceeding with equity issuance to finance expansion projects. Continual monitoring of market conditions and economic indicators will be vital to adjusting the capital structure dynamically and mitigating risks related to interest rate fluctuations and economic recession.

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