Question

Collins Manufacturing Company has determined its optimal capital structure, which is composed of the following sources and target market value proportions:

Target Market - Source of Capital Proportions

Long-term debt                     30%

Preferred stock                     10%

Common stock equity         60%

Debt: The firm can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20.

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: The firm’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years at a rate of 8%.

In order to assure that the new stock issuance will sell, it must be underpriced at $1 per share.  In addition, the firm must pay $1 per share in flotation costs.

The firm’s tax rate is 40 percent.

Required:

Calculate the firm’ weighted average cost of capital for the Collins Company assuming the firm has exhausted all retained earnings.  (That is, you must consider flotation costs for the common stock issuance.)

Answer 1

Weight of equity = E/A

Weight of equity =

W(E)=0.6

Weight of debt = D/A

Weight of debt = 0.3

W(D)=0.3

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.3 - 0.6

W(PE)=0.1

Cost of equity

As per DDM

Price-flotation cost= Dividend in 1 year/(cost of equity - growth rate)

40-1 = 5.07/ (Cost of equity - 0.08)

Cost of equity% = 21

Cost of debt

K = N

Bond Price *(1-flotation %) =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =20

980*(1-0.02) =∑ [(9*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 9.4477308056

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

After tax cost of debt = 9.4477308056*(1-0.4)

= 5.66863848336

cost of preferred equity

cost of preferred equity = Preferred dividend/price-flotation cost*100

cost of preferred equity = 8/(62-3)*100

=12.9

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=5.67*0.3+21*0.6+12.9*0.1

WACC =15.59%