Question

Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 21​% tax bracket. Debt: The firm can raise debt by selling 1,000​-par-value, 8​% coupon interest​ rate, 20​-year bonds on which annual interest payments will be made. To sell the​ issue, an average discount of ​$30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond. Preferred stock: The firm can sell 8​% preferred stock at its $95​-per-share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share. Preferred stock can be sold under these terms. Common stock: The​ firm's common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The​ firm's dividends have been growing at an annual rate of 6%, and this growth is expected to continue into the future. The stock must be underpriced by $7 per​ share, and flotation costs are expected to amount to $ 5 per share. The firm can sell new common stock under these terms. Retained earnings: When measuring this​ cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available 100,000 of retained earnings in the coming​ year; once these retained earnings are​ exhausted, the firm will use new common stock as the form of common stock equity financing.

a.  Calculate the​ after-tax cost of debt.

b.  Calculate the cost of preferred stock.

c.  Calculate the cost of common stock.

d.  Calculate the​ firm's weighted average cost of capital using the capital structure weights shown in the following​ table,

Long-term debt 30% Preferred stock 20% Common stock equity 50% Total 100%

Answer 1

Answer : Calculation of After tax cost of Debt by using Approximation Formula :

Before tax cost of Debt = {Coupon + [(Face value - Net Proceeds) / Number of years of maturity] } / [(Face value + Net Proceeds) / 2]

Coupon = 1000 * 8% = 80

Face value = 1000

Net Proceeds = Face value - Discount - Flotation Cost

= 1000 - 30 - 30

= 940

Number of years to maturity = 20

Before tax cost of Debt = {Coupon + [(Face value - Net Proceeds) / Number of years of maturity] } / [(Face value + Net Proceeds) / 2]

= {80 + [(1000 - 940) / 20] } / [(1000 + 940) / 2 ]

= 83 / 970

= 0.0855670103 or 8.55670103%

After tax cost of Debt = Before tax cost of Debt * (1 - tax rate)

= 8.55670103% * (1 - 0.21)

= 6.7597938137%

(b.) Calculation of Cost of Preferred Stock

Cost of Preferred Stock = Annual Dividend / (Par value -

= (95 * 8%) / (95 - 5)

= 7.6 / 90

= 8.44%

(c.)Calculation of Cost of Equity

Cost of Common Equity = [Expected Dividend / (Market Price - Underpricing - Flotation Cost)] + growth rate

= [7 / (90 - 7 - 5)] + 0.06

= 0.14974358974 or 14.974358974%

(d.)

WACC = (Cost of After tax Debt * Weight of Debt) + (Cost of Preferred Stock * Weight of Preferred Stock) + ( Cost of Equity * Weight of Equity)

= (8.96% * 0.30) + (8.44% * 0.20) + (14.97% * 0.50)

= 2.028% + 1.688% + 7.485%

= 11.20%