Question

Star Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter (OTC) market. During 2016, the Dallas-based company experienced sharp increases in both sales and earnings. Because of this recent growth, Melissa Jen, the company’s treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30% long-term debt, 10% preferred stock, and 60% common stock equity for at least the next 3 years. The firm is in the 40% tax bracket.

To estimate the firm’s weighted average cost of capital (WACC), Jen contacted a leading investment banking firm, which provided the financing cost data below.

Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000-parvalue, 9% coupon interest rate bonds that pay semiannual interest. It expects to net $960 per bond after flotation costs. Any debt in excess of $450,000 will have a before-tax cost, rd, of 13%.

Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $70 par value and a 14% annual dividend rate and will net $65 per share after flotation costs.

Common stock equity: The firm expects dividends and earnings per share to be $0.96 and $3.20, respectively, in 2017 and to continue to grow at a constant rate fo 11% per year. The firm’s stock currently sells for $12 per share. Star expects to have $1,500,000 of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $9 per share after underpricing and flotation costs.

You are required to:

1. Calculate the cost of each source of financing, as specified:

a. Long-term debt, first $450,000.

b. Long-term debt, greater than $450,000.

c. Preferred stock, all amounts

d. Common stock equity, first $1,500,000.

e. Common stock equity, greater than $1,500,000.

2. Calculate the weighted average cost of capital (WACC).

Answer 1

	1a	Long-term debt, first $450,000
	Pv	Net amount to be received per bond	$960
	Pmt	Semi annual coupon payment	$45.00	(1000*0.09)/2
	Nper	Number of semi annual period of payment	30	(15*2)
	Fv	Payment on maturity at end of 15 years	$1,000
	RATE	Semi annual yield	4.75%	(using RATE function of excel with Nper=30, Pmt=45, Pv=-960, Fv=1000)
		Annual Yield=(4.75*2)%	9.50%
		Before tax Cost of Long Term Debt	9.50%
	C1	After tax cost of debt =9.5*(1-0.4)	5.70%
	1b	Long-term debt, greater than $450,000
		Before tax cost	13%
		After tax cost=13*(1-0.4)=	7.80%	7.80
	C2	Cost of Long term debt , greater than 450000	7.80%
	1c	Preferred stock, all amounts
		Net amount to be received per share	$65
		Annual dividend =0.14*70	$9.80
	C3	Cost of preferred stock=(9.80/65)*100%	15.08%
	1d	Common stock equity, first $1,500,000.
		Dividend growth rate=11%=	0.11
		Next years expected dividend=0.96*1.11	$1.07
		Required rate of return =R
		Current Price =1.07/(R-0.11)
		$12=1.07/(R-0.11)
		R-0.11=1.07/12=	0.0888
		Required rate of return =R=0.11+0.0888=	0.1988
	C4	Cost of common equity	19.88%
	1e	Common stock equity, greater than $1,500,000
		Required return per share =0.1988*12	$2.39
		Net selling price of new shares	$9
	C5	Cost of equity =2.39/9=	26.51%
		Weight of long term debt=30%	0.3
		Weight of Preferred stock=10%	0.1
		Weight of common stock=60%	0.6
	2	Weighted Average Cost of Capital (WACC)
		0.3*C1+0.1*C3+0.6*C4
		0.3*5.7+0.1*15.08+0.6*19.88=	15.15%
		WACC=	15.15%