Question

What is questions (i)?

The president of Receding Airlines has asked you to calculate the company's cost of capital. To start, you have gathered the following information:

RecedingAir has the following securities outstanding:

• $1,000 face value, 8% annual coupon bonds with 15 years remaining to maturity and a current market price of $1,150.
• $100 par value preferred stock that pays an 11% annual dividend and has a current market price of $92.
• Common stock with a current market price of $50/share. Investors expect the next annual dividend to be $4.00 and to grow after that at a constant rate of 7% per year into the foreseeable future.    If RecedingAir were to issue new securities today:
• New bonds would pay interest annually, have a 15-year life, and incur a flotation cost of 3%.
• A new issue of preferred stock would pay annual dividends and incur flotation costs of 6%
• A new issue of common stock would incur flotation costs of 8%. RecedingAir’s income is taxed at a 35% marginal rate.
• RecedingAir’s target capital structure is 35% long-term debt, 15% preferred stock, and 50% common equity.
• RecedingAir forecasts it will retain $25,000,000 of earnings in the coming year.

1.    What is the required rate of return of RecedingAir’s bondholders?
2.    What is RecedingAir’s cost of debt?
3.    What is the required rate of return of RecedingAir’s preferred stockholders?
4.    What is RecedingAir’s cost of preferred stock financing?
5.    What is the required rate of return of RecedingAir’s common stockholders?
6.     What is RecedingAir’s cost of retained earnings financing?
7.    What is RecedingAir’s cost of a new common stock issue?
8.          What is RecedingAir’s weighted-average cost of capital (WACC) for its first dollar of new financing?
9. How much total new financing can RecedingAir raise before its supply of new retained earnings financing is exhausted and there is a break in the cost of capital schedule?

Answer 1

a]

Required rate of return of bondholders = YTM of bonds

YTM is calculated using RATE function in Excel with these inputs :

nper = 15 (15 years to maturity with 1 annual coupon payment each year)

pmt = 1000 * 8% (annual coupon payment = face value * annual coupon rate. This is a positive figure as it is an inflow to the bondholder)

pv = -1115.50 (net proceeds per bond = current price * (1 - flotation cost) = $1,150 * (1 - 3%) = $1,115.50. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 6.75%. This is the YTM.

Required rate of return of bondholders = 6.75%

b]

cost of debt = YTM * (1 - tax rate)

cost of debt = 6.75% * (1 - 35%) = 4.39%

c]

required rate of return of preferred stockholders = (annual dividend / price per share)

annual dividend = face value * dividend rate = $100 * 11% = $11.

required rate of return of preferred stockholders = ($11 / $92)

required rate of return of preferred stockholders = 11.96%

d]

required rate of return of preferred stockholders = (annual dividend / net proceeds per share)

annual dividend = face value * dividend rate = $100 * 11% = $11.

net proceeds per share = price of share - flotation cost

net proceeds per share = $92 - ($92 * 6%) = $86.48

cost of preferred stock = $11 / $86.48 = 12.72%