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

1-	cost of debt	9.50%
	tax rate	35%
	after tax cost of debt =cost of debt*(1-tax rate)	9.5*(1-.35)	6.175
2-	cost of preferred	preferred dividend/current market price	7.5/(122-11)	0.067568
3-	cost of retained earning (Dividend discount)	(expected dividend/market price)-growth rate	(7.29/96)+.08	0.155938
	expected dividend	6.75*(1.08)	7.29
	market price		96
	growth rate		8%
4-	cost of retained earning (CAPM)	risk free rate+(market return-risk free rate)*beta	3+(10-3)*1.75	15.25
5-	cost of new equity	(expected dividend/market price)-growth rate	(7.29/80.64)+.08	0.170402
	expected dividend	6.75*(1.08)	7.29
	market price	96-(1-.16)	80.64
	growth rate		8%
6-capital budget	net income		395840
	dividend paid	24%	95001.6
	income available as retained earning		300838.4
7-	WACC
	source	weight	cost	Weight*cost
	debt	0.17	6.175	1.04975
	preferred stock	0.12	6.765	0.8118
	common stock	0.71	15.593	11.07103
		WACC	sum of weight*cost	12.93
8-	WACC
	source	weight	cost	Weight*cost
	debt	0.17	6.175	1.04975
	preferred stock	0.12	6.765	0.8118
	common stock	0.71	17.04	12.0984
		WACC	sum of weight*cost	13.96