Full Answer Section

Calculation:

Ks = 7% + 1.3 (12% – 7%) Ks = 7% + 1.3 (5%) Ks = 7% + 6.5% Ks = 13.5%

Therefore, the estimated cost of new common stock for Allied Group is 13.5%.

Dividend Yield:

Current Dividend Yield:

Dividend Yield = (Last Dividend Paid per Share) / (Current Stock Price) Dividend Yield = ($2.25) / ($29) Dividend Yield = 0.0776 or 7.76% (approximately)

Dividend Yield in One Year:

Assuming a constant growth rate of 15% for dividends:

Dividend in One Year = Last Dividend Paid per Share * (1 + Growth Rate) Dividend in One Year = $2.25 * (1 + 15%) Dividend in One Year = $2.5875

Dividend Yield in One Year = (Dividend in One Year) / (Current Stock Price) Dividend Yield in One Year = $2.5875 / $29 Dividend Yield in One Year = 0.0892 or 8.92% (approximately)

After-Tax Cost of New Debt (Kd):

Given:

• Coupon Rate = 8%
• Tax Rate = 40%

Kd = Coupon Rate * (1 – Tax Rate) Kd = 8% * (1 – 40%) Kd = 8% * 0.6 Kd = 4.8%

Therefore, the after-tax cost of new debt for Allied Group is 4.8%.

Financing Recommendations:

Based on the analysis:

• The cost of new common stock (13.5%) is higher than the after-tax cost of new debt (4.8%).
• Issuing new debt seems financially more attractive in the short term due to its lower cost.

However, here are some additional factors to consider:

• Dilution: Issuing new common stock dilutes ownership for existing shareholders.
• Signaling Effect: Issuing debt might signal higher risk to investors compared to issuing equity.
• Financial Flexibility: Debt creates fixed interest rate obligations, while equity provides more financial flexibility.
• Market Conditions: Current interest rates, economic stability, and investor risk appetite can influence the attractiveness of debt vs. equity.

Considering these factors:

• If the current economic climate offers historically low-interest rates, debt financing might be more appealing despite dilution.
• If the company needs to maintain a strong financial structure with low debt-to-equity ratio, issuing new common stock might be preferable in the long run.

Overall Recommendation:

A balanced approach using both debt and equity financing might be optimal. Issuing some debt capitalizes on low borrowing costs, while issuing some common stock maintains ownership structure and financial flexibility. The ideal mix depends on the specific financial goals and risk tolerance of Allied Group.

It’s important to consult with financial advisors to consider all relevant factors and determine the most suitable capital raising strategy.