The Allied Group Aims To Expand Company Operations

The Allied Group Intends To Expand The Companys Operation By Making S

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. New Debt 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. Questions: Address all of the following questions in a brief but thorough manner. What is the after tax cost of new common stock, assuming constant growth in each of the next 3 years? What would the dividend yield in each of the first three years if the growth rate is 12%? What is the after tax component cost of new debt today?

Paper For Above instruction

Introduction

The financial strategy of a company plays a crucial role in determining its expansion capabilities and overall viability. When a firm like The Allied Group seeks to finance its expansion, it must evaluate various sources of capital, such as debt, common stock, and preferred stock, in terms of cost and market conditions. Understanding the specific costs associated with these sources is fundamental to optimizing capital structure and minimizing the overall cost of capital, thereby enhancing shareholder value and supporting sustainable growth.

Cost of New Common Stock

The cost of new common stock, especially under a growth scenario, can be estimated using the Gordon Growth Model, which considers the dividend per share, the price of the stock, and the growth rate of dividends. Given the last dividend paid was $2.25, and the stock price now is $29, with an estimated growth rate of 15% over the next three years, we can compute the cost of equity (re) with the formula:

\[ r_e = \frac{D_1}{P_0} + g \]

where:

- \( D_1 = D_0 \times (1 + g) \)

- \( D_0 = 2.25 \)

- \( P_0 = 29 \)

- \( g = 15\% \)

Calculating \( D_1 \):

\[ D_1 = 2.25 \times (1 + 0.15) = 2.5875 \]

Therefore, the cost of new common stock:

\[ r_e = \frac{2.5875}{29} + 0.15 \approx 0.0892 + 0.15 = 0.2392 \text{ or } 23.92\% \]

Given the assumption of constant growth, this rate reflects the return demanded by investors for taking on the risk of investing in new equity under the current market conditions, with a projected growth of 15%.

Dividend Yield in the First Three Years with 12% Growth

If the dividend growth rate is assumed to be 12% annually instead of 15%, the dividend yield in each of the first three years can be calculated based on the expected dividends and the current stock price:

- Year 1 dividend:

\[ D_1 = 2.25 \times (1 + 0.12) = 2.52 \]

Dividend yield:

\[ \frac{D_1}{P_0} = \frac{2.52}{29} \approx 8.69\% \]

- Year 2 dividend:

\[ D_2 = D_1 \times (1 + 0.12) = 2.52 \times 1.12 = 2.82 \]

Corresponding dividend yield:

\[ \frac{D_2}{P_0} \approx \frac{2.82}{29} \approx 9.72\% \]

- Year 3 dividend:

\[ D_3 = D_2 \times (1 + 0.12) = 2.82 \times 1.12 = 3.16 \]

Dividend yield:

\[ \frac{D_3}{P_0} \approx \frac{3.16}{29} \approx 10.90\% \]

These calculations illustrate how dividend yields increase as dividends grow, affecting investor returns and perceptions of stock attractiveness over time.

After-Tax Component Cost of New Debt

The cost of new debt issued at par with an 8% coupon rate is subject to income tax considerations since interest expense is tax-deductible. The after-tax cost of debt (k_d) is computed as:

\[ k_d = \text{Coupon Rate} \times (1 - \text{Tax Rate}) \]

Assuming a corporate tax rate of 21% (a common statutory rate in many jurisdictions):

\[ k_d = 0.08 \times (1 - 0.21) = 0.08 \times 0.79 = 0.0632 \text{ or } 6.32\% \]

This indicates that after tax, the effective cost of new debt for The Allied Group is approximately 6.32%, which is relatively low compared to equity costs, making debt a cost-efficient component of the company's capital structure.

Conclusion

Efficient capital structure management requires precise calculation of the costs associated with different funding sources. The cost of new common stock, influenced heavily by growth expectations and market conditions, stood around 23.92%, while the dividend yields for the first three years under a 12% growth scenario ranged from approximately 8.69% to 10.90%. The after-tax cost of debt, assuming a standard corporate tax rate, was calculated at approximately 6.32%. These figures enable The Allied Group to make informed decisions when structuring its expansion financing, balancing risk and return to maximize shareholder value.

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