Question

Calculate the weighted average cost of capital for a firm with the following information:

            Marginal corporate tax rate:                                                               25%

            Bonds with $1,000 face value with a 6% coupon rate

   with semi-annual payments matures in 10 years now sells for               $928.94

            Preferred stock dividend                                                                        $5.50

            Preferred stock price                                                                               $55.00

Current common stock dividend per share                                               $1.50

            Price per share of common stock                                                             $12.00

            Floatation cost to sell new common stock                                              10%

            Forecast rate of growth for corporation                                                   4%

            Risk free interest rate                                                                            4%

            Market rate of return                                                                             12%    

Beta for firm                                                                                        1.4

            Long-term debt                                                $30,000

            Preferred stock                                                 10,000

            Retained Earnings                                            30,000

            Common Stock                                                40,000

                                                                                    $100,000

1 What is the cost of new funds raised by issuing debt?

2 What is the cost of new funds from new preferred stock?

3 What is the cost of retained earnings? (no floatation costs)

    1.) Using dividend growth model

    2.) Using CAPM model

1. What is the cost of funds from issuing new shares of common stock

(has floatation costs) with the dividend growth model?

1. What is the weighted average cost of capital using the dividend growth model?

Answer 1

1. Using financial calculator to calculate the ytm of the bond

Inputs:- N= 10 × 2 = 20

Pv= -928.94

Pmt= 6% / 2 × 1,000 = 30

Fv= 1,000

I/y= compute

We get, ytm of the bond as 3.5% × 2 equal to 7%

Cost of debt before tax = 7%

After tax cost of debt = 7% (1-0.25)

= 7% (0.75)

= 5.25%

2) Cost of preferred stock = annual dividend/ current price

= 5.5 / 55

= 10%

3) a) Ddm model (without floatation cost)

Required return = dividend (1+growth rate) / price + growth rate

= 1.5 / (1+0.04) / 12 + 0.04

= 1.5 (1.04) / 12 + 0.04

= 1.56 / 12 + 0.04

= 0.13 + 0.04

= 17%

B) CAPM model

Expected return = risk free rate + beta (market return- risk free rate)

= 4% + 1.4 (12% - 4%)

= 4% + 1.4 (8%)

= 4% + 11.2%

= 15.2%

C) DDM (with floatation cost)

Required return = dividend (1+growth rate) / (price - 10% of price) + growth rate

= 1.5 (1+0.04) / (12 - 10% of 12) + 0.04

= 1.5 (1.04) / (12 - 1.2) + 0.04

= 1.56 / 10.8 + 0.04

= 0.1444 + 0.04

= 18.44%