Question

Individual

or component costs of

capital​)

Compute the costs for the following sources of​ financing:

a. A

$1,000

par value bond with a market price of

$ 940

and a coupon interest rate of

7

percent. Flotation costs for a new issue would be approximately

5

percent. The bonds mature in

13

years and the corporate tax rate is

36

percent.

b. A preferred stock selling for

$ 115

with an annual dividend payment of

$ 12

The flotation cost will be

$9

per share. The​ company's marginal tax rate is 30 percent.

c. Retained earnings totaling

$4.8

million. The price of the common stock is

$ 85

per​ share, and dividend per share was

$ 9.55

last year. The dividend is not expected to change in the future.

d. New common stock for which the most recent dividend was

$ 3.33

The​ company's dividends per share should continue to increase at a growth rate of

9

percent into the indefinite future. The market price of the stock is currently

$ 55;

​however, flotation costs of

$ 5

per share are expected if the new stock is issued.

Answer 1

Follwings are the individual costs of capital calculated:

a) Cost of debt = After tax YTM (Yield to maturity)

YTM = (Coupon + ((F - M) / n)) / ((F + M) / 2))

Here,

F (Face value) = $1,000

M (Market price) = Price * (1 - Flotation cost @ 5% or 0.05) = $940 * (1 - 0.05)

M = $893

n (year) = 13

Tax rate = 36% or 0.36

Coupon = Face value * Coupon rate

Coupon = $1,000 * 7% = $70

Now,

YTM = ($70 + (($1,000 - $893) / 13)) / (($1,000 + $893) / 2)

YTM = ($70 + $8.23) / $946.50

YTM = $78.23 / $946.50

YTM = 0.0827

After tax cost of debt = YTM * (1 - Tax rate)

After tax cost of debt = 0.0827 * (1 - 0.36)

After tax cost of debt = 0.0529 or 5.29%

b) Cost of preferred stock = Dividend / (Price - Flotation cost)

Cost of preferred stock = $12 / ($115 - $9)

Cost of preferred stock = $12 / $106

Cost of preferred stock = 0.1132 or 11.32%

Note : Ignore details of tax rate, as dividends are paid from net income after paying tax on it.

c) Cost of retained earnings = Dividend / Price

Cost of retained earnings = $9.55 / $85

Cost of retained earnings = 0.1124 or 11.24%

Note : Ignore amount of retained earnings.

d) Cost of common stock = (D1 / (Price - Flotation cost)) + g

Here,

g (growth rate) = 9% or 0.09

D1 (expected dividend) = Recent dividend + growth rate

D1 = $3.33 + 9% = $3.63

Price = $55

Flotation cost = $5

Now,

Cost of common stock = ($3.63 / ($55 - $5)) + 0.09

Cost of common stock = ($3.63 / $50) + 0.09

Cost of common stock = 0.0726 + 0.09

Cost of common stock = 0.1626 or 16.26%