The entrepreneur of a new Start-Up company is studying the way to obtain 6 million € of capital in the long term. Its Financing advisor suggested the following alternative capital structures:
Alternative A- 2,000,000 € debt at 9% 4,000,000 € Equity
Alternative B - 4,000,000 € debt at 11% 2,000,000 € Equity
With alternative A the company would sell 200,000 common shares to obtain a net revenue of 20€ per share. Shareholders would expect an inicial dividend of 1€ per share and a growth rate of dividends equal to 7%.
With alternative B the company would sell 100,000 common shares to obtain a net revenue of 20€ per share. The expected dividend would be 0,8€ per share and the growth rate of dividends is forecasted at 12%.
Assume that the company will generate positive profits with both capital structures, and that the corporate tax rate is 50%.
a) What is the cost of capital of the company with each of the two alternative capital structures?
b) Explain why the interest rate on debt is higher in alternative B Show your work.