Question

Benes Inc. has the following financial information:

Debt: The firm issued 1,000, 20 year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 7.8%. Preferred Stock: Pays an 8.9% preferred dividend with a par of $100 and is currently selling for $82. Equity: Benes’ common stock currently sells for $35 and grows at a constant rate of 5%. Benes will pay a $2.25 dividend to their shareholders. Benes’ business plan for next year projects net income of $540,000, half of which will be retained. The company applies an average tax rate of 35% for cost of capital decision-making purposes. Benes Inc. pays flotation costs of 10% on all new stock issues. Benes’ capital structure is 40% debt, 10% preferred stock and 50% common equity. Compute the capital component costs for each of the capital components (debt, preferred stock and equity using retained earnings). Ignore flotation costs for debt and preferred stock.

Calculate the WACC before the break in retained earnings.

Calculate Davola’s break point in retained earnings.

Calculate the WACC after the break in retained earnings. In other words, calculate the WACC given the point that the firm will have to issue new stock to fund the equity portion of its capital budget.

Answer 1

The firm issued 20-year bonds five years ago at par value of $ 1000 (bond market price was equal to the par value of $1000 at issue) with an annual coupon of 7.8 %

As the bonds sold at the par value, the bond's YTM = Coupon Rate = 7.8 %

Pre-Tax Cost of Debt = kd = 7.8 %

Preferred Stock Dividend = 8.9 % of Par Price of $ 100 = 0.089 x 100 = $ 8.9

Market Price of Preferred Stock = Mp = $ 82

Cost of Preferred Stock = kp = 8.9 / 82 = 0.1085 or 10.85 %

Current Common Stock Price = P0 = $ 35, Expected Dividend = D1 = $ 2.25, Dividend Growth rate = g = 5 %

Cost of Common Stock = ke = (D1/P0) + g = (2.25 / 35) + 0.05 = 0.1143 or 11.43 %

Target Capital Structure: Debt = D = 0.4, Preferred Stcok = P = 0.1 and Common Stock = C = 0.5

The firm has a net income of $ 540000, half of which is paid off as dividend and the other half is kept as retained earnings. This implies that the firm would look at raising new equity only after its retained earnings of $ 270000 is exhausted. Beyond this point equity part of investments would need to be funded through issuance of new common stock which carry a flotation cost of 10%.

Tax Rate = 35 %

WACC before break-in retained earnings (before retained earnings are exhausted) = 0.5 x 11.43 + 0.1 x 10.85 + 0.4 x (1-0.35) x 7.8 = 8.83 %

Retained Earnings Break Point = 270000 / 0.5 = $ 540000

Post Breakeven, only the cost of equity would undergo a change owing to the presence of floatation costs. Floatation Costs for debt and preferred stock.

Cost of Equity with floatation cost incorporated = ke' = [D1/P0 x (1-f)] + g = [2.25 / 35 x (1-0.1)] + 0.05 = 0.1333 or 13.33 %

WACC after break in the retained earnings = 0.5 x 13.33 + 0.1 x 10.85 + 0.4 x (1-0.35) x 7.8 = 9.778 %

NOTE: The incorporation of flotation cost into the discounting rate means that all future cash flows of the firm would be discounted at the rate incorporating the flotation cost, thereby implying that the flotation cost is an ongoing cost. However, the flotation cost is only a one-time cost incurred at issuance of new stock and hence the cash outflow impact of flotation cost needs to be determined in $ terms at the beginning of the project (for which new equity is being issued as capital). Once determined the same is added to the initial project outlay (investment) to incorporate the impact of flotation cost. The cost of equity to be used for WACC calculation is then the original pre-new stock issuance cost of equity (11.43 % in this case).
In solving this problem, however, we have solved by incorporating flotation cost into the cost of equity as an ongoing cost.