Question

The stock of Matrix Computing sells for $65, and last year’s dividend was $2.53. Security analysts are projecting that the common dividend will grow at a rate of 9% a year. A flotation cost of 12% would be required to issue new common stock. Matrix’s preferred stock sells for $42.00, pays a dividend of $3.32 per share, and new preferred stock could be sold with a flotation cost of 10%. The firm has outstanding bonds with 25 years to maturity, a 15% annual coupon rate, semiannual payments, $1,000 par value. The bonds are trading at $1,271.59. The tax rate is 20%. The market risk premium is 5.5%, the risk-free rate is 7.0%, and Matrix’s beta is 1.2. In its cost-of-capital calculations, Matrix uses a target capital structure with 40% debt, 10% preferred stock, and 50% common equity.

a. Calculate the cost of each capital component—in other words, the after-tax cost of debt, the cost of preferred stock (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the CAPM method and the dividend growth approach to find the cost of equity.

b. Calculate the cost of new stock using the dividend growth approach.

c. Assuming that Matrix will not issue new equity and will continue to use the same tar-get capital structure, what is the company’s WACC

Answer 1

a.

After tax cost of debt is 4.89%

Cost of preferred stock is 8.78%

Cost of equity under CAPM is 13.60%

Cost of equity under Dividend growth approach is 13.62%

b. Cost of new stock

Cost of new stock using Dividend growth approach is 14.26%

c. Calculation of WACC

WACC of the company is 9.63%