Question

Carling Corporation will raise $1,000,000 to finance an expansion. They plan to raise $500,000 through the sale of bonds, $ 50,000 by issuing preferred stock, $300,000 by issuing Common stock and $150,000 by using retained earnings. (you are going to need this total) The company will have to contract with an investment banker to issue bonds, new preferred stock and new common stock. The firm uses the CAPM approach to value retained earnings, but is willing to consider other options. Its bonds sell for $1,000 have a 9% coupon rate, mature in 20 years and will incur a floatation cost of 4% per bond. The firm could sell, at par, $100 preferred stock which pays a 6% annual dividend, with flotation costs of 5%. Carling's beta is 1.1, the Return on Government Notes is 6%, and the market return is 12%. Carling has a growth rate of 8% and its current stock price $24.00 with recent dividends of $2.00, per share. Floatation costs are 6% on new issues. The firm's policy is to use a risk premium of 5.3% When using the bond-yield-plus-risk-premium method to value Retained earnings. The firm's marginal tax rate is 40%.

What would be the cost of using retained earnings if the company used the bond-yield-plus-risk-premium method?

a) 10.87

b)14.75

c) 10.32

d) 12.60

e)7.62

f)5.67

G) 6.32

H)17.57

I) 9.45

What is the cost of using retained earnings valued using the CAPM?. What is the cost of issuing common stock?

a) 10.87

b)14.75

c) 10.32

d) 12.60

e)7.62

f)5.67

G) 6.32

H)17.57

I) 9.45

What is the cost of issuing Preferred stock? What is the cost of using bond to finace the expansion?

a) 10.87

b)14.75

c) 10.32

d) 12.60

e)7.62

f)5.67

G) 6.32

H)17.57

I) 9.45

Calculate the WACC.

a) 10.87

b)14.75

c) 10.32

d) 12.60

e)7.62

f)5.67

G) 6.32

H)17.57

I) 9.45

Answer 1

a) Cost of retained earnings using bond yield plus risk premium method

Yield of bond = (C+ (F-P)/n) / ((F+P)/2)

= (90+ (1000-960)/20) / ((1000+960)/2)

= 9.38%

Note: Purchase price = face value - floatation costs

COst of retained earnings = bond yield + risk premium

= 9.38% + 5.3%

= 14.75%

Hence answer is B.

2) Cost of retained earnings using CAPM

r_a = r_f + beta *(r_m - r_a)

= 0.06 + 1.1 * (0.12-0.06)

= 12.6%

Hence, answer is d.

Cost of issuing common stock = D₁ / P₀ (1-f) + g

= (2*1.08) / 24(1-0.06) + 0.08

= 17.57%

Hence answer is h.

Cost of issuing preferred stock = dividend / price of stock (1-f)

= 6.32%

Hence answer is g

Cost of issuing bond

After tax cost of debt = bond yield * (1-tax rate)

= 9.38%(1-0.4)

= 5.67%

Hence answer is f

WACC of the company

	Value	Cost of capital	Weights	Weighted cost
Debt	5,00,000	0.056	0.50	0.03
Common stock	3,00,000	0.176	0.30	0.05
Preferred stock	50,000	0.063	0.05	0.00
Retained earniings	1,50,000	0.147	0.15	0.02
Total	10,00,000			10.87%

Hence answer is a.