Question

Global Internet company is looking to expand their operations. They are evaluating their cost of capital based on various financing options. Investment bankers informed them that they can issue new debt in the form of bonds at a cost of 8%, and issue new preferred stocks for the price of $25 per share paying $2.5 dividends per share. Their common stock is currently selling for $20 per share and will pay a dividend of $1.5 per share next year. They expect a growth rate in dividends of 5% per year, and their marginal tax rate is 35%.

1. If Global raises capital using 45% debt, 5% preferred stock, and 50% common stock what is their cost of capital?
2. If Global raises capital using 30% debt, 5% preferred stock, and 65% common stock what is their cost of capital?
3. Evaluate the two finance options and identify which one they should choose? Assess the advantages and disadvantages of your choice?

Answer 1

Requirement (b) - Cost of capital if Global raises capital using 45% debt, 5% preferred stock, and 50% common stock

After Tax Cost of Debt

After Tax Cost of Debt = Interest on Debt x [ 1 – Tax Rate]

= 8.00% x (1 – 0.35)

= 8.00% x 0.65

= 5.20%

Cost of Preferred Stock

Cost of Preferred Stock = [Annual Preferred Dividend / Selling Price] x 100

= [$2.50 / $25.00] x 100

= 10.00%

Cost of Equity

As per Discounted cash flow model, The cost of common stock = [D0(1 + g) / P0] + g

Where, Dividend in next year (D1) = $1.50 per share

Dividend growth rate (g) = 5.00% per year

Current Share Price (P0) = $20.00 per share

Therefore, cost of common stock = [D1 / P0] + g

= [$1.50 / $20.00] + 0.05

= 0.0750 + 0.05

= 0.1250 or

= 12.50%

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.20% x 0.45] + [10.00% x 0.05] + [12.50% x 0.50]

= 2.34% + 0.50% + 6.25%

= 9.09%

“The Cost of capital will be 9.09%”

Requirement (b) - Cost of capital if Global raises capital using 30% debt, 5% preferred stock, and 65% common stock

After Tax Cost of Debt

After Tax Cost of Debt = Interest on Debt x [ 1 – Tax Rate]

= 8.00% x (1 – 0.35)

= 8.00% x 0.65

= 5.20%

Cost of Preferred Stock

Cost of Preferred Stock = [Annual Preferred Dividend / Selling Price] x 100

= [$2.50 / $25.00] x 100

= 10.00%

Cost of Equity

As per Discounted cash flow model, The cost of common stock = [D0(1 + g) / P0] + g

Where, Dividend in next year (D1) = $1.50 per share

Dividend growth rate (g) = 5.00% per year

Current Share Price (P0) = $20.00 per share

Therefore, cost of common stock = [D1 / P0] + g

= [$1.50 / $20.00] + 0.05

= 0.0750 + 0.05

= 0.1250 or

= 12.50%

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.20% x 0.30] + [10.00% x 0.05] + [12.50% x 0.65]

= 1.56% + 0.50% + 8.13%

= 10.19%

“The Cost of capital will be 10.19%”