Question

COST OF CAPITAL

With several new investment opportunities, it is necessary for you to first know AB Designs’ weighted average cost of capital (WACC). This critical information will inform your analysis on what investments are profitable along with identifying the best financing option.  

Business Problem:

AB Designs capital structure is composed of the following sources and target weights that represent the proportion of use for each. AB Designs tax rate is 40%.

Source of Capital	Weight
Long-term loan	10%
Long-term bonds	30%
Preferred Stock	5%
Common Stock Equity	55%

Debt:

AB Designs has a long-term loan with North Shore bank, financed at a 10% interest rate.

AB Designs can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20.

Preferred Stock:

AB Designs has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock:

AB Design’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation costs.    

Identify AB Designs’ WACC.  

Answer 1

Before tax cost of loan = 10%

Tax rate = 40%

After tax cost of loan = 10% × (1 - 40%)

= 6.00%

After tax cost of long term loan is 6.00%.

Before tax cost of long term bond is calculated in excel and screen shot provided below:

Before tax cost of loan term bond is 9.45%.

Tax rate = 40%

After tax cost of long term bond = 9.45% × (1 - 40%)

= 5.67%

After tax cost of long term bond is 5.67%.

Cost of preferred stock = Annual Dividend / Net proceeds from sale

= $8 / ($65 - $3)

= 12.90%

Cost of preferred stock is 12.90%.

Cost of equity

Growth rate in dividend = ($5.07 / $3.45) ^ (1 / 5) - 1

= 1.08 - 1

= 8%

Growth rate in dividend is 8%.

Net proceed fromsale of equity = $40 - $1 - $1

= $38.

Cost of equity = (Expected dividend / Net proceed from equity) + Growth rate

= ($5.07 / $38) + 8%

= 13.34% + 8%

= 21.34%

Cost of equity is 21.34%

Now, WACC is calculated below:

WACC = (10% × 6%) + (30% × 5.67%) + (5% × 12.90%) + (55% × 21.34%)

= 0.60% + 1.70% + 0.65% + 11.74%

= 14.68%

WACC of company is 14.68%.