Question

COST OF CAPITAL ASSIGNMENT

STEPHANIE’S CAJUN FOODS, INC NEEDS TO DETERMINE THEIR COST OF CAPITAL FOR CAPITAL BUDGETING PURPOSES. THEY HAVE ASSEMBLED THE FOLLOWING INFORMATION:

MARKET PRICE OF OUTSTANDING BONDS                                                                        95

COUPON RATE – SEMI-ANNUAL PAYMENTS                                                              11.0%

MATURITY VALUE                                                                                                            $ 1,000

YEARS TO MATURITY                                                                                                             25

FLOTATION COSTS                                                                                                                  2%

CORPORATE TAX RATE                                                                                                        21%

MARKET PRICE OF OUTSTANDING PREFERRED                                                       $      50

PAR VALUE                                                                                                                         $      25

DIVIDEND (PERCENTAGE OF PAR)                                                                                   10%

FLOTATION COSTS                                                                                                                  1%

MARKET PRICE OF COMMON STOCK                                                                      $           60

CURRENT STOCK DIVIDEND                                                                                     $        7.50

GROWTH RATE                                                                                                                      4.0%

FLOTATION COSTS                                                                                                               5.0%

TARGET CAPITAL STRUCTURE

            BONDS                                  10.00%

            PREFERRED STOCK           20.00%

            COMMON STOCK               30.00%

            RETAINED EARNINGS      40.00%

           

THE CURRENT CAPITAL STRUCTURE, BASED ON BOOK VALUES, APPEARS AS FOLLOWS:

            BONDS                                                                                  $ 20,000,000

            PREFERRED STOCK                                                                1,000,000

            COMMON STOCK (PAR $10)                                                30,000,000

            RETAINED EARNINGS                                                         80,000,000

CALCULATE:         

A)   THE COMPONENT COSTS OF CAPITAL

2. THE WEIGHTED AVERAGE COST OF CAPITAL AT BOOK VALUE WEIGHTS
3. THE WEIGHTED AVERAGE COST OF CAPITAL AT MARKET VALUE WEIGHTS
4. THE WEIGHTED AVERAGE COST OF CAPITAL AT TARGET VALUE WEIGHTS

Answer 1

Using financial calculator
N=25*2
PV=-95*(1-2%)
FV=100
PMT=11%*100/2
CPT I/Y=5.934%

Hence, yield to maturity=5.934%*2=11.867%

Pre tax cost of debt=yield to maturity=11.867%

After tax cost of debt=Pre tax cost of debt*(1-tax rate)=11.867%*(1-21%)=9.375%

Cost of preferred stock=Dividend %*Par/(Price*(1-flotation cost))=10%*25/(50*(1-1%))=5.051%

Cost of common stock using retained earnings=Current Dividend*(1+Growth rate)/(Price)+growth rate=7.50*1.04/(60)+4%=17.000%

Cost of common stock using external financing=Current Dividend*(1+Growth rate)/(Price*(1-flotation cost%))+growth rate=7.50*1.04/(60*(1-5%))+4%=17.684%

WACC at book value weights=(20*9.375%+1*5.051%+80*17.000%+30*17.684%)/(20+1+30+80)=15.901%

WACC at market value weights=(20*95%*9.375%+1/25*50*5.051%+80*17.000%+30/10*60*17.684%)/(20*95%+1/25*50+80+30/10*60)=16.838%

WACC at target value weights=(10%*9.375%+20%*5.051%+40%*17.000%+30%*17.684%)=14.053%