Question

Edna Recording​ Studios, Inc., reported earnings available to common stock of $4,000,000 last year. From those​ earnings, the company paid a dividend of $1.34 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 30% debt, 15% preferred stock, and 55% common stock. it is taxed at a rate of 26%.

a.  If the market price of the common stock is ​$46 and dividends are expected to grow at a rate of 9​% per year for the foreseeable​ future, what is the​ company's cost of retained earnings financing​?

b.  If under pricing and flotation costs on new shares of common stock amount to ​$9 per​ share, what is the​ company's cost of new common stock financing​?

c.  The company can issue ​$1.99 dividend preferred stock for a market price of ​$30 per share. Flotation costs would amount to ​$2 per share. What is the cost of preferred stock financing​?

d. The company can issue ​$1,000​-par-value, 11​% coupon, 12​-year bonds that can be sold for ​$1290 each. Flotation costs would amount to ​$20 per bond. Use the estimation formula to figure the approximate​after-tax cost of debt​ financing?

e. What is the WACC​?

Answer 1

a]

cost of retained earnings = (next year dividend per share / current price per share) + growth rate

next year dividend per share = last year dividend per share * (1 + growth rate)

next year dividend per share = $1.34 * (1 + 0.09) = $1.4606

cost of retained earnings = ($1.4606 / $46) + 0.09

cost of retained earnings = 12.18%

b]

cost of new common stock = (next year dividend per share / net proceeds per share) + growth rate

net proceeds per share =  current price per share - costs of issue

net proceeds per share = $46 - $9 = $37

cost of new common stock = ($1.4606 / $37) + 0.09

cost of new common stock = 12.95%

c]

cost of preferred stock = annual dividend per share / net proceeds per share

net proceeds per share = price per share - costs of issue

net proceeds per share = $30 - $2 = $28

cost of preferred stock = $1.99 / $28 = 7.11%

d]

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

YTM = [annual interest + (par value - net proceeds) / years to maturity] / [(par value + net proceeds) / 2)

annual interest = par value * coupon rate = $1000 * 11% = $110

net proceeds = sale price - flotation cost = $1290 - $20 = $1270

YTM = [110 + (1000 - 1270) / 12] / [(1000 + 1270) / 2]

YTM = 7.71%

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

after-tax cost of debt = 7.71% * (1 - 26%) = 5.70%