Question

Baby Boo Ltd. is considering the broadening of its horizons and is looking at investing into the Oil & Gas industry. Before any analysis of the cash flows can begin, the CEO, Mr. Big Shot, must select an appropriate discount rate. Having just completed FNCE3323 at NAIT, you suggest the calculation of the cost of capital.

The following is the existing capital structure of Baby Boo Ltd.

Bonds (Original maturity 15 yrs.) $32,000,000

Preferred shares $15,000,000

Common shares $20,000,000

Retained earnings $25,000,000

Total $92,000,000

The bonds, which have been outstanding for five years, have a coupon rate of 8%, which compounds annually. Current market yields on this risk security are 10.5%. Flotation costs would be 2% of the issue price. The existing preferred shares have a $50 par value and a fixed dividend rate of 10%. New preferred shares could be issued at $50 par value with a 7% yield. Flotation expenses of a new issue of preferreds would be 2% of the issue price. The common shares, of which there are 2.5 million outstanding, are currently trading at $24.00 per share. The dividend next year is expected to be $1.75 per share, which will grow at 8% annually, particularly if this new project does not go belly up. New shares will be priced at $23. Flotation expenses would be 5 percent of the share price. The tax rate for Baby Boo Ltd. is 35%. The investment dealer has advised the company that internally generated funds will not be sufficient to finance new capital investments and therefore, new shares will have to be issued.

Answer 1

Wno1) Computation of current market price of bond:

Year	Type	Cash flow	Present value factor @ 10.5%	Discounted cashflow
1	Coupon	8.00	1/1.105 = 0.905	7.2400
2	Coupon	8.00	0.905/1.105 = 0.819	6.5520
3	Coupon	8.00	0.819/1.105 = 0.7412	5.9296
4	Coupon	8.00	0.7412/1.105 = 0.6708	5.3664
5	Coupon	8.00	0.6708/1.105 = 0.6071	4.8568
5	Redemption value	100.00	0.6708/1.105 = 0.6071	60.7100
Current market price of the bond	90.6548

Assumed par value = $100; Coupon = $100*8% = $8

Wno 2) Calculation of cost of bond:

I = $8; NP = Current market price - floatation cost = 90.6548 - 2%*90.6548 = 90.6548 - 1.8131 = $88.8417; RV = $100; t = 0.35; n = 5

Cost of bond (Kd) = {8*(1-0.35)+[(100-88.8417)/5]}/[(100+88.8417)/2]

= {(8*0.65)+(11.1583/5)}/(188.8417/2) = (5.2+2.23166)/94.420852 = 7.43166/94.420852 = 0.0787 or 7.87%

Wno 3) Computation of cost of preferred stock:

Assumed preferred stock is irredeemable.

PD = par value*7% = $50*7% = $3.5;

P0 = Perpetual cashflow/required yield - flotation expenses = [(50*10%)/7%] - 2% on issue price = (5/0.07) - 2% on issue price = 71.4286 - 2%*71.4286 = 71.4286 - 1.4286 = $70

Cost of preferred stock (Kp) = $3.5/$70 = 0.05 = 5%

Wno 4) Computation of cost of equity:

F = New issue price*5% = $23*5% = $1.15; D1 = $1.75; P0 = $24; g=8%

Cost of equity (Ke) = [1.75/(24-1.15)]+8% = (1.75/22.85)+8% = 7.66%+8% = 15.66%

Wno 5) Calculation of cost of retained earnings:

D1 = $1.75; P0 = $24; g=8%

Kr = (1.75/24)+8% = 7.29%+8% = 15.29%

Wno 6) WACC

Type	Cost	Existing capital structure (in $ million)	Weight	Weighted average cost of capital
Bond	7.87%	32	32/92 = 0.3478	7.87%*0.3478 = 2.74%
Preferred stock	5.00%	15	15/92 = 0.1630	5%*0.1630 = 0.82%
Common stock	15.66%	20	20/92 = 0.2174	15.66%*0.2174 = 3.40%
Retained earnings	15.29%	25	25/92 = 0.2717	15.29%*0.2717 = 4.15%
		92		11.11%