Question

Edna Recording Studios, Inc., reported earnings available to common stock of $4,800,000 last year. From those earnings, the company paid a dividend of $1.22 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 35% debt, 15% preferred stock, and 50%common stock. It is taxed at a rate of 35%.

a.If the market price of the common stock is $37 and dividends are expected to grow at a rate of 7% per year for the foreseeable future, what is the company's cost of retained earnings financing

b.If underpricing and flotation costs on new shares of common stock amount to $7 per share, what is the company's cost of new common stock financing

c.The company can issue $1.81 dividend preferred stock for a market price of $30 per share. Flotation costs would amount to $2 per share. What is the cost of preferred stock financing?

d.The company can issue $1,000-par-value,12% coupon, 9-year bonds that can be sold for $1,150 each. Flotation costs would amount to $20 per bond. Use the estimation formula to figure the approximate after-tax cost of debt financing?

e.What is the WACC??

Answer 1

Answer a.

Current Price, P0 = $37
Growth Rate, g = 7%
Recent Dividend, D0 = $1.22

D1 = D0 * (1 + g)
D1 = $1.22 * 1.07
D1 = $1.3054

Cost of Retained Earnings = D1 / P0 + g
Cost of Retained Earnings = $1.3054 / $37 + 0.07
Cost of Retained Earnings = 0.1053 or 10.53%

Answer b.

Flotation Cost, F = $7

Cost of New Common Stock = D1 / [P0 - F] + g
Cost of New Common Stock = $1.3054 / [$37 - $7] + 0.07
Cost of New Common Stock = 0.1135 or 11.35%

Answer c.

Annual Dividend, D = $1.81
Current Price, P = $30
Flotation Cost, F = $2

Cost of Preferred Stock = D / (P - F)
Cost of Preferred Stock = $1.81 / ($30 - $2)
Cost of Preferred Stock = 0.0646 or 6.46%

Answer d.

Face Value, F = $1,000
Current Price net of flotation cost, P = $1,130 ($1,150 - $20)
Annual Coupon, C = 12%*$1,000 = $120
Time to Maturity, N = 9 years

Approximate YTM = [C + (F - P) / n] / [(F + P) / 2]
Approximate YTM = [$120 + ($1,000 - $1,130) / 9] / [($1,000 + $1,130) / 2]
Approximate YTM = $105.56 / $1,065
Approximate YTM = 9.91%

After-tax Cost of Debt = 9.91% * (1 - 0.35)
After-tax Cost of Debt = 6.4415%

Answer e.

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Equity*Cost of New Common Stock + Weight of Preferred Stock*Cost of Preferred Stock
WACC = 35%*6.4415% + 50%*11.35% + 15%*6.46%
WACC = 8.90%