Question

Calculation of individual costs and WACC   Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the

30​%tax bracket.

Debt  The firm can raise debt by selling

​$1000 par-value,

9​%

coupon interest​ rate,

17​-year

bonds on which annual interest payments will be made. To sell the​ issue, an average discount of

​$25

per bond would have to be given. The firm also must pay flotation costs of

​$20

per bond.

Preferred stock  The firm can sell

8%

preferred stock at its

​$90-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

​$85

per share. The firm expects to pay cash dividends of

​$7.5

per share next year. The​ firm's dividends have been growing at an annual rate of

8​%,

and this growth is expected to continue into the future. To sell new shares of common​ stock, the firm must underprice the stock by

​$8

per​ share, and flotation costs are expected to amount to

$ 6

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

​$150,000

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, (Round answer to the nearest​ 0.01%)

Long-term debt   35%
Preferred stock   10%
Common stock equity   55%
Total   100%

Answer 1

Solution:

a)Calculation of after tax cost of debt

Sale proceeds of bond=$1000-25-20=$955

Cost of bond=[Annual Coupon+(Face Value-Sale Proceeds)/Years to maturity]/(Face Value-Sale Proceeds)/2

=[$90+($1000-$955)/17]/($1000+$955)/2

=0.0948 or 9.48%

After Tax cost of debt=Cost of debt(1-tax rate)

=9.48%(1-0.30)=6.64%

b)Cost of Preferred stock

Cost of Preferred stock=Dividend/(Share Price-Flotation cost)

=$8/(90-5)

=$0.0941 or 9.41%

c)Calculation of cost of common stock

Since,nothing is given about,whether the fund will raise through isssue of new stock or retained earning,hence cost is calculated using new issue of shares

Cost of common stock=[Expected dividend/Share Price-Flotation cost]+Growth rate

=[$7.5/($85-$8)-$6]+0.08

=($7.5/$71)+0.08

=0.1856 or 18.56%

d)Calculation of WACC

WACC=Cost of equity*Weight+Cost of preferred stock*weight+After tax cost of debt*Weight

=18.56%*0.55+9.41%*0.10+9.48%*0.35

=14.467% or 14.47%