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 8 percent. The bonds mature in 5 years and the corporate tax rate is 35 percent.

b. A preferred stock selling for $113 with an annual dividend payment of $11.

The flotation cost will be $7 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 $76 per​ share, and dividend per share was $9.19 last year. The dividend is not expected to change in the future.

d. New common stock for which the most recent dividend was $2.99. The​ company's dividends per share should continue to increase at a growth rate of 7

percent into the indefinite future. The market price of the stock is currently $62​; however, flotation costs of $6 per share are expected if the new stock is issued.

Answer 1

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

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

Here,

F (Face or par value) = $1,000

P (Net market price) = Market price * (1 - Flotation cost @ 8% or 0.08)

P = $940 * (1 - 0.08) = $864.80

n (years) = 5

Coupon = Par value * Coupon rate

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

Tax rate = 35% or 0.35

Now,

YTM = ($70 + (($1,000 - $864.80) / 5)) / (($1,000 + $864.80) / 2)

YTM = ($70 + 27.04) / $932.40

YTM = $97.04 / $932.40

YTM = 0.1041

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

After tax cost of debt = 0.1041 * (1 - 0.35)

After tax cost of debt = 0.0677 or 6.77%

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

Cost of preferred stock = $11 / ($113 - $7)

Cost of preferred stock = $11 / $106

Cost of preferred stock = 0.1038 or 10.38%

Note : Ignord marginal tax rate.

c) Cost of retained earnings = Dividend / Price

Cost of retained earnings = $9.19 / $76

Cost of retained earnings = 0.1209 or 12.09%

Note : Ignore amount of retained earnings

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

Here,

g (growth rate) = 7% or 0.07

D1 (Expected dividend) = Recent dividend + growth rate

D1 = $2.99 + 7% = $3.199

Price = $62

Flotation cost = $6

Now,

Cost of new stock = ($3.199 / ($62 - $6)) + 0.07

Cost of new stock = ($3.199 / $56) + 0.07

Cost of new stock = 0.0571 + 0.07

Cost of new stock = 0.1271 or 12.71%