Financial Ratios

3378 words 14 pages
Part A
After-TAX Cost Debt
O’Grandy Apparel Company can calculate the after tax debt cost using YTM (CP + (FV-Nd /n) / FV +Nd /2) *2. Cp is (0.12/2) * 1000= 60 Semi-annually Fv is 1000 Nd is 995 – (0.025* 1000) = 970
N is 20*2 because it is semi-annually then you have to use Kdt= Kd+ (i-T) .The tax bracket is 40 percent. Now we can have the after tax debt when it is equal or smaller than $700000
Kd ( 1-T) = 0.1249 (1-0.4)= 0.07494. If it is more than $700000 it will be KD (1-t) = 0.18(1-0.4) = 0.108
The Cost of Preferred Equity
If o’grady Apparel Company wants to raise financing using preferred shares, it could use Po = D/K KPS=D/Pn . so, 17% annual dividend rate times $60 (stated value) which is Dt is 10.2. After that 10.2
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The WACC in the range of $1-$1.4 million of financing is 15.07%, the WACC in the range of $1.400,0001-$3,250,000 is 16.71%, and the WACC in the range of $3.250,0001 and above is 17.59%. Another major difference between the two scenarios is that the firm would start financing with long-term debt because it is the cheapest form of financing at 15.07%, and then move on to common equity as needed since it is the more expensive form of financing. This strategy is the complete opposite than that found with the original capital structure (see exhibit 4b).
A third difference between the original capital structure, and the new highly levered capital structure on the firm’s investment opportunities can be found in the calculation of the overall cost of capital (OCC).
(I am assuming that Erin already explained what the overall KD is)The OCC is calculated by dividing the ranges by the cumulative amount of investment opportunities, and then multiplying the result by the WACC for each range. As it can be seen from (Exhibit 3 Erin’s exhibit), the original OCC of 20.19% only allows the company to take on investments A,C,D, and F; whereas the OCC for the highly levered capital structure is 16.40%, providing the firm with the opportunity to take on every investment because 16.40% (the firms expected return) is lower than all expected return of potential investments. For this reason, the new capital structure is seen to be superior to the old structure (see exhibit 4c).
If the firm

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