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In: Finance
It is your job to determine your company’s marginal cost of capital schedule. The firm’s current...
It is your job to determine your company’s marginal cost of capital schedule. The firm’s current capital structure, which it considers optimal, consists of 30% debt, 20% preferred stock, and 50% common equity. The firm has determined that it can borrow up to $15 million in debt at a pre-tax cost of 7%, an additional $9 million at a pre-tax cost of 9%, and any additional debt funds at 11%. The firm expects to retain $25 million of its earnings; any additional income can be raised by issuing new common stock. The firm’s common stock currently trades at $30 per share, and it pays a $3.00 per share dividend. Dividends are expected to grow at a 5% annual rate over time. If the firm issues new common stock it will be sold to the public at a 10% discount. There will also be a $2.00 per share flotation cost. Preferred stock can be issued in unlimited quantities at a pre-tax cost of 12%. If the firm decides to raise more than $80m in capital, what is the cost of that capital? Assume a tax rate of 40%.
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Expert Solution
| Weighted average cost of debt | |||
| Amt. | Wt. to total | After-tax cost | Wt.*Cost |
| 15 | 18.75% | 4.20% | 0.79% |
| 9 | 11.25% | 5.40% | 0.61% |
| 80-24=56 | 70.00% | 6.60% | 4.62% |
| 80 | 100.00% | 6.02% | |
| Cost of retained earnings |
| ke=(Next dividend/Market price)+growth rate of dividends |
| ((3*1.05)/30)+5%= |
| 15.50% |
| Cost of new equity |
| ke=(Next dividend/Net proceeds of new issue)+growth rate of dividends |
| ((3*1.05)/((30*(1-10%)-2))+5%= |
| 17.60% |
| Cost of Preferred stock= |
| 12% |
| Given that |
| it considers optimal, consists of 30% debt, 20% preferred stock, and 50% common equity |
| and also that |
| the firm expects to retain $25 million of its earnings |
| balance 80-25= $ 55 millions need to be raised from outside |
| in the ratio of 30%,20% & 50% respectively of |
| debt,preferred stock & new common equity |
| Now, with the weights & the 3 respective costs known , |
| the weighted average cost of outside capital,ie. WACC |
| The WACC=(Wt.d*kd)=(Wt.ps*kps)+(Wt.e*ke) |
| ie.(30%*6.02%)+(20%*12%)+(50%*17.60%)= |
| 13.01% |
| the company’s marginal cost of capital,including the cost of retained earnings= |
| ((55/80*13.01%)+(25/80*15.5%)= |
| 13.79% |
| (ANSWER) |
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