Question

A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Additionally, the firm's marginal tax rate is 40 percent

                                            Source of Capital      Market Proportions

Long- term debt                       20%

Preferred stock                        10

Common stock equity              70             

Debt: The firm can sell a 12- year, $1,000 par value, 7 percent annual bond for $880. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. Common Stock: A firm's common stock is currently selling for $30 per share. The dividend expected to be paid at the end of the coming year is $1.5. Its dividend payments have been growing at a constant rate of 8%

A. What is the firm’s cost of common stock?

B. What is the firm’s cost of preferred stock?

C. What is the firm’s cost of debt?

D. What is the firm’s weighted average cost of capital?

Answer 1

Given about a firm,

A). Given about its common stock,

current price P0 = $30

dividend next year D1 = $1.5

dividend growth rate g = 8%

=> cost of equity on stock using Gordon's growth rate is

Ke = D1/P0 + g = 1.5/30 + 0.08 = 13%

=> firm’s cost of common stock = 13%

B). Given about its preferred stock,

current price P = $75

annual dividend = $10

=> cost of preferred stock using perpetuity model is

Kp = D1/P0 = 10/75 = 13.33%

=> firm’s cost of preferred stock = 13.33%

C). its bonds has following feature,

Current price = $880

Face value = $1000

coupon rate = 7% paid annually

So, annual coupon = 7% of 1000 = $70

years to maturity = 12 years,

Yield to maturity of the bond can be calculated on financial calculator using following values:

FV = 1000

PV = -880

PMT = 70

N = 12

Compute for I/Y, we get I/Y = 8.65

So, YTM of the bond = 8.65%

For a company, its pretax cost of debt Kd equals its bond's YTM

So, company's pretax cost of debt Kd = 8.65%

D). tax rate T = 40%

Weight of debt Wd = 20%

Weight of preferred stocK Wp = 10%

Weight of equity We = 70%

=> WACC of the company = Wd*Kd*(-T) + Wp*Kp + We*Ke = 0.2*8.65*(1-0.4) + 0.1*13.33 + 0.7*13 = 11.47%

=> firm’s weighted average cost of capital = 11.47%