Question

The firm’s marginal tax rate is 21%. • The market price of todd’s 7.5 % coupon, semiannual payment, noncallable bonds with 10 years remaining to maturity is $1,250 • todd does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. • The current price of the firm’s perpetual preferred stock (8%, $100 par value, quarterly dividend) is $102.10. todd would incur flotation costs of $3 per share on a new issue. • todd common stock is currently selling at $48 per share. Its last dividend (D0) was $2.90, and dividends are expected to grow at a constant rate of 4.5% in the foreseeable future. • todd's beta is 1.3, the yield on Treasury bills 2%, and the market risk premium is estimated to be 6.5%. • For the bond-yield-plus-risk-premium approach, the firm uses a 3.5% risk premium. • Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000, the flotation cost would rise to 25%. • todd target capital structure is 35 % long-term debt, 5% preferred stock, and 60% common equity. • The firm is forecasting retained earnings of $300,000 for the coming year.

**you don't need to use all the inputs

What is todd’s overall cost of capital (WACC) when retained earnings are used as the equity component?

Answer 1

WACC=(weight of debt*after tax cost of debt)+(weight of preferred stock*cost of preferred stock)+(weight of equity*cost of equity)

After tax cost of debt=before tax cost of debt*(1-tax rate)

before tax cost of debt can be found using RATE function in EXCEL

The payments are semi-annual

=RATE(nper,pmt,pv,fv,type)

nper=number of periods=2*10=20

pmt=semi-annual coupon payment=(7.5%*1000)=75/2=37.5 (1000 is the face value of the bond)

pv=1250

fv=1000

=RATE(20,37.5,-1250,1000)

RATE=2.19%

Annual yield=before tax cost of debt=2*2.19%=4.39%

After tax cost of debt=4.39%*(1-21%)=3.46%

Cost of preferred stock=Annual dividend/(preferred stock-flotation cost)

=8/(102.10-3)

=8.07%

Cost of equity using dividend growth model= (D1/current share price)+growth rate

D1=D0*(1+g)=2.9*(1+4.5%)=3.0305

Cost of equity=(3.0305/48)+4.5%

=10.81%

weight of debt= 35 % ,

preferred stock=5%

common equity=60%

WACC=(35%*3.46%)+(5%*8.07%)+(60%*10.81%)=8.10%