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The Allied Group is oriented toward investing more resources in its new common stock and preferred stock, as well as in new bond issues. The analysis of these options is required with the focus on the cost of capital in order to understand the potential benefit related to realizing these options. The purpose of this report is to determine the cost of new common stock for the Allied Group, calculate the dividend yield, compute the after-tax cost of new debt, and provide recommendations regarding raising capital.
The Cost of New Common Stock Using CAPM
While calculating the cost of new common stock using the Capital Asset Pricing Model (CAPM), the focus should be on determining the required rate of return in relation to one asset (Ks). In this context, it is important to analyze the risk-free rate of return, the stock’s beta coefficient, and the risk premium rate (Brigham & Houston, 2016). The following formula is used for CAPM: Ks = Krf + (Km – Krf) * bi, where Krf is the risk-free rate (7% for the Allied Group), (Km – Krf) is the risk premium (12%), and bi is the beta coefficient (1.3). As a result, for the Allied Group Ks = 7% + 12% * 1.3 = 22.6%, that is the cost of new common stock or the required rate of return.
The Dividend Yield
The dividend yield is calculated as D1/P0, where D1 is dividends ($2.25 per share in the case of the Allied Group), and P0 is the stock price ($29 per share). For today, the dividend yield is 2.25 / 29 = 7.76%. The expected growth rate for new common stock is 15% per year for the next three years, and in a year, it is possible to expect dividend yield that equals (2.25 * 115%) / 29 = 8.89% (Brigham & Houston, 2016; Vallabhaneni, 2018). However, if the dividend growth rate equals 12% in a year, dividend yield will be (2.25 * 112%) / 29 = 8.69%, that is lower than the previously calculated figure for 15%.
The After-Tax Cost
In order to compute the after-tax cost of new debt (Kd) for today, it is necessary to pay attention to the annual coupon of 8% (the interest rate) and the tax rate in 40%. In this context, Kd = the interest rate * (100% – 40%), where (100% – 40%) is the net cost of debt without taxes (Vallabhaneni, 2018). Thus, in this case, Kd = 8% * (100% – 40%) = 4.8%. The reference to the interest rate for calculating the after-tax cost is reasonable in this case because it is stated that new bonds will be sold at par ($1000).
Recommendations for Raising the Allied Group’s Capital
There are several sources of raising capital that can be used by the Allied Group in order to address its capital needs. It is possible to choose between using the company’s internal funds, common and new stocks, as well as preferred stocks, debt, option securities, and leasing. From this perspective, capital can be raised mainly through equity (including new common and preferred stocks) or selling more ownership shares and debt or borrowing more resources (Brigham & Houston, 2016; Vallabhaneni, 2018).
While comparing the options available for the Allied Group, it is important to focus on the following data: the cost of equity according to the CAPM is 22.6%, the cost of the company’s preferred stock is 10%, and the after-tax cost of new debt is 4.8%.
These figures demonstrate that the cost of debt is the lowest one, and it should be taken into account while raising capital because it depends only on the interest rate, and the focus on borrowing more money does not involve equity holders. Still, choosing this option, the Allied Group should analyze changes in interest and tax rates, inflation rates, and associated changes in the country’s economy that can influence inflation in the future along with the company’s debt.
If inflation rates are high, and the overall economic and social situation in the country is unstable, high borrowings cannot be recommended even if their costs are comparably low. Still, while focusing on raising capital through selling more shares, it is also important to analyze potential changes in the country’s and global economy, as well as changes in the market’s supply and demand. The reason for this step is to understand what position will be taken by the Allied Group in the future and whether it will be competitive in its market segment.
The analysis of the Allied Group’s capital structure allows for providing certain recommendations in the context of the company’s interest in financing more common stocks and bonds. It is possible to assume that the Allied Group’s current financial state allows for focusing more on debt and bonds rather than on equity. However, in order to achieve significant increases in the company’s capital, it is also necessary to analyze the potential impact of external factors, including inflation rates, tax rates, and interest rates.
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage Learning.
Vallabhaneni, S. R. (2018). Wiley CIAexcel exam review 2018, part 3: Internal audit knowledge elements. New York, NY: John Wiley & Sons.