Exam 10: The Cost of Capital and the Capital Structure Decision

Last year Monaco Hotels distributed $26.25 million in dividends to its seven million common shareholders. Monaco Hotels is planning a $75 million resort hotel in Tobago. The expected income before income taxes is $20 million of which 25% will be distributed to the 7 million common shareholders over and above the amount of dividends equivalent to those distributed last year. Common shares trade for $42 per share. 1.3 million Class A cumulative preferred shares trade for $16.40 and carry a dividend of $1.23 per share. The company can fund the project through an issue of a new class of irredeemable cumulative preferred shares priced at $14 a share with a return rate similar to that of the Class A shares. Alternatively, it can issue of bonds with a face value of $1,000 and an interest rate of 6.8%. Applying a tax rate of 24% and ignoring issuing costs, which option will provide the highest incremental EPS from the project?

What would be an important consequence if the CEO of a company required the Finance Department to use a cost of capital rate 2% lower than the true value?