Week 10 Activity - Financial Calculations Overview
Week 10 Activity - Financial Calculations Overview These problems are related to content covered in Chapter 6
These problems are related to content covered in Chapter 6. Completing them now will help to prepare you for your final exam. Instructions 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. 1. 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? 2. 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? 3. 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
Sample Paper For Above instruction
Assets and capital structure decisions are fundamental to financial management, impacting a firm's valuation, risk, and overall corporate strategy. Chapter 6 emphasizes key concepts such as leverage, cost of capital, and the tax implications of debt, providing tools to optimize capital structure for maximized shareholder value. The following analysis addresses three specific financial problems to illustrate these principles in practice.
1. Calculating the Annual Interest Tax Shield
Salinas Corporation's potential debt issuance of $20 million at a 7% interest rate provides a tangible benefit known as the interest tax shield. This shield capitalizes on the tax deductibility of interest expenses, effectively reducing taxable income. The calculation entails multiplying the interest expense by the corporate tax rate:
Interest Expense = $20 million × 7% = $1.4 million
Tax Shield = Interest Expense × Tax Rate = $1.4 million × 40% = $560,000
Thus, the annual tax shield attributable to the debt issuance is $560,000. This benefit enhances after-tax cash flows and can be a decisive factor in leveraging debt to finance growth.
2. Determining the Number of Shares to Issue
Carbon8's goal is to raise $120 million net. The underwriting fee ($1.25 per share), underpricing of 7.5%, and additional costs, all influence the gross proceeds needed from investors. First, calculate the public offering price per share considering underpricing:
Price per share (offering) = Current stock price / (1 - Underpricing) = $28.00 / (1 - 0.075) = $28.00 / 0.925 ≈ $30.27
Next, account for the underwriter's fee per share and additional costs:
Gross proceeds per share = $30.27 - $1.25 (underwriter fee) = $29.02
Total funding needed before costs = $120 million + $785,000 = $120,785,000
Finally, determine the number of shares to sell:
Number of shares = Total funds / Net proceeds per share = $120,785,000 / $29.02 ≈ 4,160,679 shares
Rounding appropriately, Carbon8 must issue approximately 4.16 million shares to meet its fundraising goal.
3. Estimating FM Foods' After-Tax Cost of Equity
The cost of equity reflects the return required by investors, considering the firm's risk profile. Using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium
= 4.4% + 1.20 × 6.5% = 4.4% + 7.8% = 12.2%
This estimate aligns with market expectations for a company with a beta of 1.20. The after-tax cost of debt can be calculated as:
Cost of Debt = Yield to Maturity × (1 - Tax Rate) = 6.3% × (1 - 0.40) = 3.78%
Given the firm's capital structure, the weighted average cost of capital (WACC) can be derived, but the primary focus here is the cost of equity for risk assessment. The calculated 12.2% provides a benchmark for evaluating investment opportunities and financing strategies.
Conclusion
These problems exemplify the application of financial theory to real-world decision-making. The interest tax shield enhances firm value through tax savings, the share issuance calculation informs capital raising efforts, and the CAPM-derived cost of equity guides investment and financing decisions. Mastery of these concepts enables financial managers to balance risk and return, optimize capital structures, and ultimately deliver value to shareholders.
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