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

A) interest on Debt , I = 9.5% = 0.095

tax rate = t = 35% = 0.35

cost of debt = I*(1-t) = 9.5*(1-0.35) = 6.175% or 6.18% ( rounding off to 2 decimal places)

B)

preference dividend , d1 = $7.50

preference share price , p1 = $122

floatation cost , f = $11

cost of preference capital = d1/(p1-f) = 7.50/(122-11) = 7.5/111 = 0.067567 or 6.7567% or 6.765 ( rounding off to 2 decimal places)

C)

constant growth rate for dividends , g = 8% = 0.08

last dividend paid , d0 = $6.75

dividend expected next year , d1 = d0*(1+g) = 6.75*(1.08) = $7.29

current stock price , p0 = $96

cost of retained earnings = (d1/p0)+g = (7.29/96)+0.08 = 0.1559375 or 15.59375% or 15.59% ( rounding off to 2 decimal places)

D)

beta = b = 1.75

treasury bond yield , r1 = 3%

expected rate of return for average stock , r2 = 10%

As per CAPM

cost of retained earnings = r1 + [b*(r2-r1)] = 3 + [1.75*(10-3)] = 3 + 12.25 = 15.25%

E)

floatation cost , f1 = 16% = 0.16

constant growth rate for dividends , g = 8% = 0.08

last dividend paid , d0 = $6.75

dividend expected next year , d1 = d0*(1+g) = 6.75*(1.08) = $7.29

current stock price , p0 = $96

cost of new equity = (d1/(p0*(1-f1)) + g = (7.29/(96*(1-0.16)) + 0.08 = (7.29/80.64) + 0.08 = 0.170401 or 17.0401% or 17.04% ( rounding off to 2 decimal places)