Question

Badmmans Firearms Company has the following capital structure, which it considers to be optimal: debt = 17%, preferred stock = 12%, and common equity = 71%.

Badman’s tax rate is 35%, and investors expect earnings and dividends to grow at a constant rate of 8% in the future. Badman's expected net income this year is $395,840, and its established dividend payout ratio is 24%. Badmans paid a dividend of $6.75 per share last year (D 0 ), and its stock currently sells for $96 per share. Treasury bonds yield 3%, an average stock has 10% expected rate of return, and Badmans beta is 1.75. These terms apply to new security offerings:
Common: New common stock would have a floatation cost of 16%.

Preferred: New preferred could be sold to the public at $122 per share with a dividend of $7.50. Floatation costs of $11 would be made.

Debt: Debt may be sold at an interest of 9.5%.

Find the following:

A: Component cost of debt

B: Component cost of preferred

C: Component cost of retained earnings (DCF)

D: Component cost of retained earnings (CAPM)

E: Component cost of new equity (DCF)

F: Capital budget before Badmans must sell new equity (the breakpoint)

G: WACC retained earnings

H: WACC new equity

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J	K	L
2
3		A)
4
5		Cost of Debt:
6
7		Cost of debt will be the yield to maturity of the bonds or the interest rate at which it is sold.
8
9		Interest rate at which debt has been sold	0.095
10
11		Hence cost of Debt	=D9
12
13		B)
14
15		Calculation of cost of preferred stock:
16		Cost of preferred stock can be calculated as follows:
17		Annual Dividend of preferred stock	7.5
18		Current Price	122
19		Floatation cost (F)	11
20		Cost of preferred stock	=Dividend/(Current Price-F)
21		Cost of preferred stock	=D17/(D18-D19)	=D17/(D18-D19)
22
23		Hence Cost of Preferred Stock is	=D21
24
25		C)
26
27		Calculation of Cost of retained earnings using dividend growth:
28
29		Dividend This Year (Div 0)	6.75
30		Price	96
31		Growth rate	0.08
32		Floatation cost (F)	0
33		From Dividend growth model,
34		r(E) = (Div0*(1+g)/P*(1-F))+g
35
36		Cost of equity=	=(D29*(1+D31)/D30*(1-D32))+D31	=(D6*(1+D8)/D7*(1-D9))+D8
37
38		Hence cost of Equity is	=D36
39
40		D)
41
42		Calculation of Cost of retained earnings using CAPM:
43		As Per CAPM, Expected rate of return can be calculated as
44		r(E) = rf + ?*(rm-rf)
45		Using the Following data
46		Beta (?)	1.75
47		Risk free rate ( rf )	0.03
48		Market rate of return (rm)	0.1
49
50		Expected rate of return can be calculated as follows:
51		Expected rate of return	= rf + ?*(rm-rf)
52			=D47+D46*(D48-D47)	=D47+D46*(D48-D47)
53
54		Hence Cost of Equity is	=D52
55
56		E)
57
58		Cost of new Equity can be calculated using dividend growth model as follows:
59
60		Dividend This Year (Div 0)	6.75
61		Price	96
62		Growth rate	0.08
63		Floatation cost (F)	0.16
64		From Dividend growth model,
65		r(E) = (Div0*(1+g)/P*(1-F))+g
66
67		Cost of equity=	=(D60*(1+D62)/D61*(1-D63))+D62	=(D60*(1+D62)/D61*(1-D63))+D62
68
69		Hence cost of new Equity is	=D67
70
71		F)
72
73		Weight of common equity, Long-term debt and preferred equity are as follows:
74
75			Weight
76		Long Term Debt	0.17
77		Preferred Stock	0.12
78		Common Equity	0.71
79
80		Retained Earnings	=Net income*(1-Payout Rate)
81			=$395,840*(1-24%)
82			=395840*(1-24%)
83
84		Since retained earnings is internal source of financing, therefore break point can be calculated on the basis of retained earnings as below:
85		MCC point	=Limit on equity / % of common Equity
86		Limit on equity	=Retained Earnings
87			=D82
88
89		Breakpoint	=Limit on equity / % of common Equity
90			=D87/D78	=D87/D78
91
92		Hence breakpoint is	=D90
93
94		G)
95
96		Source of capital	Capital Structure	Cost
97		Debt	=$D$76	=$D$11
98		Common Stock	=$D$78	=(D54+D69)/2	(Cost of Retained Earnings)
99		Preferred Stock	=$D$77	=$D$23
100
101		Tax Rate	0.35
102
103		MCC	= r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
104			=D98*E98+D99*E99+D97*E97*(1-D101)	=D98*E98+D99*E99+D97*E97*(1-D101)
105
106		Hence WACC for retained earnings is	=D104
107
108		H)
109
110		Source of capital	Capital Structure	Cost
111		Debt	=$D$76	=$D$11
112		Common Stock	=$D$78	=D69	(Cost of Retained Earnings)
113		Preferred Stock	=$D$77	=$D$23
114
115		Tax Rate	0.35
116
117		MCC	= r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
118			=D112*E112+D113*E113+D111*E111*(1-D115)	=D98*E98+D99*E99+D97*E97*(1-D101)
119
120		Hence WACC for new equity is	=D118
121