Question

1. Crypton Electronics has a capital structure consisting of 40 percent common stock and 60 percent debt. A debt Issue of $1,000 par value, 6 percent bonds that mature in 15 years and pay annual interest will sell for $975. Common stock of the firm is currently selling for $30 per share and the firm expects to pay a $2.25 dividend next year. Dividends have grown at the rate of 5 percent per year and are expected to continue to do so for the foreseeable future. What is Crypton’s cost of capital where the firm’s tax rate is 30 percent?

Answer 1

Cost of Equity

As per Gordon's Growth Model

Price of share = Dividend of the following year/ (Cost of equity - growth rate)

Given:

Price of share = $30

Dividend of the following year = $2.25

Cost of equity = To find?

Growt Rate = 5%

Solution:

Price of share = Dividend of the following year/ (Cost of equity - growth rate)

30 = 2.25 / (Cost of equity - .05)

(Cost of equity - .05) =  2.25 /30

(Cost of equity - .05) =  0.075

Cost of equity = 0.075 +.05

Cost of equity = 0.125 = 12.5%

Cost of Debt:

Year	Cash Flow	Calclation (Refer Notes)	PV @6%	Calculation (Refer Notes)	PV @ 7%
1-15	60	PVAF(6%,15) =9.7122	582.73	PVAF(7%,15) =9.1079	546.47
15	1000	PVF(6%,15) = 0.4173	417.3	PVF(7%,15) = 0.3624	362.4
			1000.03		908.87
		Less:Selling Cost	975		975
			25.03		66.13

Internal rate of Return (IRR) = 6 + [25.03 /(25.03 +66.13)]

IRR = 6+ 0.2745

IRR = 6.27% = Cost of Debt

Weighted Average cost of capital (WACC) = Weight of common Stock * Cost of Equity + Weight of Debt * Rate of Debt (1-Tax Rate)

WACC = 0.40 * 12.5 + 0.60 * 6.27 (1-.30)

WACC = 5 + 2.6334

WACC = 7.6334%

Answer : Crypton's Cost of Capital = 7.6334%

Working Note :

PVAF = Present Value Annuity Factor = It is used when we pay similar amount($60) for particular paeriod(15 years)

Formula = {[1/(1+r)]ⁿ -1} / r

@ 6% = {[1/(1+.06)]¹⁵ -1} / .06 = 9.7122

@7%{[1/(1+.07)]¹⁵ -1} / .07 = 9.1079

PVF = Present Value of factor = It is used when we have to calculate present value of any single amount payable in future

@ 6% = {[1/(1+.06)]¹⁵ = 0.4173

@7%= {[1/(1+.07)]¹⁵ = .03624