Question

Dexter Brothers Inc. reported net income available to common shareholders of $4,200,000 last financial year. The company has paid $1.20 dividend per share for the 1,000,000 common shares outstanding. The company’s capital structure is included of 40 percent debt, 10 percent preferred shares and 50 percent common shares. The company were taxed at 40 percent. *

(a) If the common shares are priced at $50 and the dividend is expected to grow at 5 percent per year for the foreseeable futures, determine the company’s cost of retained earnings. (b) If underpricing and flotation costs on new common share amount to $10.00 per share, compute the company’s cost of new common share financing. (c) The company can issue $2.00 dividend preferred shares for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. Calculate the cost of new preferred stock financing. (d) The company is considering to issue new bond with a par value of $1,000, 8 percent coupon rate with 5 years maturity. The company’s old bond currently trading at $1,100 per bond. Flotation cost would amount to $25 per bond. Calculate the new cost of debt financing. (e) Determine the Dexter Brothers new weighted average cost of capital (WACC) if the company decided to issue new shares. (f) Currently Dexter Brothers is in view of accepting a new project offering return of 8 percent. Should the company accept or reject the project. Justify your answer.

Answer 1

Answer : Calculation of Cost of Retained Earning :

Retained Earning = [Expected Dividend / Current Price ] + growth rate

= [1.20 * ( 1 + 0.05)] / 50 ] + 0.05  

= [1.26 / 50] + 0.05

= 0.0752 or 7.52%

Calculation of Cost of Common Stock :

Cost of Common Stock = [Expected Dividend / (Current Price - Flotation Cost) ] + growth rate

= [1.20 * ( 1 + 0.05)] / ( 50 - 10) ] + 0.05  

= [1.26 / 40] + 0.05

= 0.0815% or 8.15%

Calculation of Cost of Preferred Stock :

Cost of Preferred Stock = [Dividend / (Current Price - Floatation Cost)] * 100

= [ 2 / (25 - 3)] * 100

= 9.090909%

Calculation of New cost of debt financing :

Using Financial Calculator

=RATE(nper,pmt,pv,fv)

where nper is Number of years to maturity i.e 5

pmt is Interest payment i.e 1000 * 8% = 80

pv is (Current Market Price - Flotation Cost)

= - 1075 (1100 - 25)

Note : pv should be taken as negative.

fv is face value i.e 1000 (Assumed)

=RATE(5,80,-1075,1000)

therefore ,Before tax cost of Debt is 6.20937%

After tax cost of Debt = 6.20937 * (1 - Tax rate )

= 6.20937 * (1 - 0.40)

= 3.73%

Calculation of WACC when cost of retained earning is used

WACC = (Cost of After tax Debt * Weight of Debt) + (Cost of Preferred Stock * Weight of Preferred Stock) + ( Cost of Equity * Weight of Equity)

= (3.73% * 0.40) + (9.090909% * 0.10) + (7.52% * 0.50)

= 1.49% + 0.909090909% + 3.76%

= 6.16%

Calculation of WACC when cost of Common Stock is used

WACC = (Cost of After tax Debt * Weight of Debt) + (Cost of Preferred Stock * Weight of Preferred Stock) + ( Cost of Equity * Weight of Equity)

= (3.73% * 0.40) + (9.090909% * 0.10) + (8.15% * 0.50)

= 1.49% + 0.909090909% + 4.075%

= 6.47%

It should accept the project offering return of 8 percent as Overall cost of the firm is lower than the required rate of return of the project.