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Explain and calculate the costs of different capital components—debt, preferred stock, retained earnings, and common stock.

  • Explain and calculate the costs of different capital components—debt, preferred stock, retained earnings, and common stock.

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Expert Solution

Calculation of the cost of debt :

Suppose a bond with face value of $1000 is selling at a price of $850. The coupon rate is 8% and the time to maturity is 8 years. The tax rate is 25%.

So, we can calculate the cost of debt (I/Y ) as,

FV = $1000

PV = ($850)

PMT = 80

N = 8 YEARS

Calculate I/Y

I/Y = 10.9049

So ,the after tax cost of debt is = 8.1787%

= 8.18%

The cost of preferred stock can be calculated as :

Rp = Dividend paid / current price of preferred stock

Suppose a bond with par value of $100, dividend paid on stock is 5%, the stock is currently selling at $95.

So, the cost of preferred stock is :

Rp = $5/ $95 ( The dividend needs to be calculated on the par value)

= 5.26%

The cost of retained earnings is :

Re = D1/Po + g

For example, if your projected annual dividend is $1.10, the growth rate is 8 percent, and the cost of the stock is $35, your formula would be as follows:

Cost of Retained Earnings = ($1.1 / $35) + 0.08 = .116, or 11.14 percent.

The cost of common stock is :

Re = D1/Po (1 - f) + g

For example, if your projected annual dividend is $1.10, the growth rate is 8 percent, and the cost of the stock is $35,the flotation costs is 2%  your formula would be as follows:

So, the cost of equity is (common stock is )

Re = $1.1/ $35(1 - 0.02) + 0.08

= $1.1/ $34.3 + 0.08

= 11.21%

jeff jeffy answered 6 months ago
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