Items 1 through 2 are based on the following information:
A new company requires $1 million of financing and is considering two arrangements as shown in the table below.
|
Arrangement |
Amount of equity raised |
Amount of debt financing |
Before-tax cost of debt |
|
#1 |
$700,000 |
$300,000 |
8% per annum |
|
#2 |
$300,000 |
$700,000 |
10% per annum |
In the first year of operations, the company is expected to have sales revenues of $500,000, cost of sales of $200,000, and general and administrative expenses of $100,000. The tax rate is 30%, and there are no other items on the income statement. All earnings are paid out as dividends at year-end.
If the cost of equity were 12%, then the weighted-average cost of capital under Arrangement #1, to the nearest full percentage point, would be
- 8%
- 10%
- 11%
- 12%
Which of the following statements comparing the two financing arrangements is true?
- The company will have a higher expected gross margin under Arrangement #1.
- The company will have a higher degree of operating leverage under Arrangement #2.
- The company will have higher interest expense under Arrangement #1.
- The company will have higher expected tax expense under Arrangement #1.