Question

Filips Inc. is trying to estimate cost of capital.

-Filips believes that the appropriate weight of debt is 35% and the approximate weight of equity is 65%

- Filips has a tax rate of 30%

- Filip's bonds currently trade in the market for a price of $835. these $1,000 par value bonds have a coupon rate of 10% (annual coupon payments) and they mature in 28 years.

-Filip's common stock trades for $22 per share. the dividend just paid by Filips was $3.15(D0=3.15) and future dividends are expected to grow at a rate of 4% per year forever.

What is Filips cost of capital?

Answer 1

Solution :- Expected dividend in the next year = Last dividend paid + Growth in dividends.

= 3.15 + 4 % of 3.15

= 3.15 + 0.126

= $ 3.276

Cost of equity capital = (Expected dividend in next year / Current price per share) + Growth rate of dividend.

= (3.276 / 22) + 0.04

= 0.1489 + 0.04

= 0.1889 i.., 18.89 %

Cost of debt capital (before tax) = [ Coupon amount on bond + (Redeemable value of bond - Net proceeds) / Number of years to maturity for bond ] / [ (Redeemable value of bond + Net proceeds) / 2 ]

= [ 10 % of 1000 + (1000 - 835) / 28 ] / [ (1000 + 835) / 2 ]

= (100 + 165 / 28) / (1835 / 2)

= (100 + 5.893) / 917.50

= 105.893 / 917.50

= 0.1154 i.e., 11.54 %

Cost of debt (after tax) = Cost of debt capital (before tax) * (1 - Tax rate)

= 11.54 % * (1 - 0.30)

= 11.54 % * 0.70

= 8.078 % (approx)

Cost of capital for Filips Inc. = Weight of equity * Cost of equity + Weight of debt * Cost of debt capital.

= 0.65 * 18.89 % + 0.35 * 8.078 %

= 12.2785 % + 2.8273 %

= 15.1058 (Rounded off to 15.11 %)

Conclusion :- Cost of capital for Filips Inc. = 15.11 % (approx).