Question

Carpetto Technologies is looking to estimate its cost of capital for capital budgeting purposes. Their in-house capital budgeting division has gathered the following information for this purpose: Carpetto currently has 25 year, $1000 par bonds, trading at a price of $967.37. These bonds pay a coupon of 6.8% per year annually. If the firm issues new bonds, it will incur flotation costs of 3% on the bonds. Carpetto’s 8.75% annual dividend paying, $100 par preferred stock currently sell in the market at a price of $97 per share. Carpetto will incur a flotation cost of 5% if it issued new preferred stock. Carpetto’s common stock sells for $61 per share, its last dividend of $2 which it paid yesterday is expected to grow at a constant rate of 7% per year into the future. New common stock will additionally impose flotation costs of 8% on the firm. Carpetto’s beta is 1.6. The firm has estimated the risk-free rate to be 4%, and the market risk premium to be 3.8%. The firm’s target capital structure is 25% debt, 15% preferred stock, and 60% common equity. Carpetto has estimated that they will earn about $18 million in net income this year, of which they expect to payout 35% as dividends. The firm has a marginal tax rate of 34%.  Please use Excel spreadsheets to analyze the problems. On the spreadsheet please show all inputs and work clearly.

a) Compute Carpetto’s before-tax and after-tax cost of debt.  

b) Compute Carpetto’s cost of preferred stock.  

c) Estimate Carpetto’s average cost of internal equity using all the methods possible. d) Estimate Carpetto’s average cost of external equity.  

e) Estimate Carpetto’s WACC before and after it exhausts all its retained earnings. f) How much retained earnings does Carpetto have available this year for reinvestment? g) What is the firm’s retained earnings breakpoint?

Answer 1

a) cost of debt is the yield to maturity of bonds.

Maturity (in years)	25
Par value	$1,000
current price	$967.37
coupon rate	6.80%
flotation costs	3%
Annual coupon	$68.00
net current price for new issue	$938.35
Yield to maturity	7.35%
marginal tax rate	34%
before-tax cost of debt	7.35%
after-tax cost of debt	4.85%

Calculation

b) Cost of preferred stock is 9.50%.

annual dividend rate	8.75%
Par value	$100
annual dividend	$8.75
current price of preferred stock	$97
flotation costs	5%
net current price for new issue	$92.15
Cost of preferred stock	9.50%

Calculation

c) average cost of internal equity can be estimated using dividend discount model (DDM) and capital asset pricing model (CAPM).

DDM
last dividend	$2.00
dividend growth rate	7%
next expected dividend	$2.14
current price of common stock	$61
cost of internal equity	10.51%
CAPM
Stock beta	1.60
risk-free rate	4%
Market risk premium	3.80%
cost of internal equity	10.08%

Calculation

d) average cost of external equity

DDM
last dividend	$2.00
dividend growth rate	7%
next expected dividend	$2.14
current price of common stock	$61
flotation costs	8%
adjusted net current price	$56.12
cost of external equity	10.81%

Calculation