Question

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1. Crypton Electronics has a capital structure consisting of 40 percent common stock and 60 percent...

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?

Expert Solution

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

jeff jeffy answered 2 years ago

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