Question

Financial Management

Chapter 9 Case

1. CompU has a target capital structure of 30 percent debt and 70 percent equity. It has $280,000 in retained earnings. CompU’s investment banking firm has advised them that they can issue $300,000 of secured debt. The $300,000 issue will consist of 10-year, $1,000 par value bonds that pay 9% and can be sold for $938.55. Flotation costs for debt is negligible and can be ignored. Flotation costs for new common stock are $1 per share; the expected stock price is $7.00. The last dividend paid was $0.80 and they expect the dividends to grow at a constant growth rate of 6% into the foreseeable future. CompU’s marginal tax rate is 40%.

1. What is the after-tax cost of debt?
2. What is the cost of retained earnings?
3. What is the cost of new common stock?
4. What is the weighted average cost of capital using retained earnings?
5. What is the weighted average cost of capital using new common stock?

2. CellU, the company CompU is looking at purchasing, has a target capital structure of 80% debt, 5% preferred stock, and 15% equity. CellU can raise $1.5 million in debt by issuing 12% mortgage bonds (before tax). Flotation costs for debt are 1% of the $1,000 par value. Preferred stock has a fixed 13% dividend rate. The firm can sell their preferred stock for the par value of $100 minus a 5% flotation cost. The firm paid a common stock dividend of $2.50 last year and has a constant growth rate of 8%. Flotation costs for common stock are 15% of the current stock price of $18. The firm’s current retained earnings are $300,000, and the firm’s marginal tax rate is 40%.

1. What is the after-tax cost of debt?
2. What is the cost of preferred stock?
3. What is the cost of retained earnings?
4. What is the cost of new common stock?
5. What is the weighted average cost of capital using retained earnings?
6. What is the weighted average cost of capital using new common stock?

Answer 1

	CompU:
a)	Before tax cost of debt = YTM.
	YTM using an online calculator =	10.00%
	After tax cost of debt = 10.00%*(1-40%) =	6.00%
b)	Cost of retained earnings = 0.80*1.06/7+0.06 =	18.11%
c)	Cost of new equity = 0.80*1.06/6+0.06 =	20.13%
d)	WACC with retained earnings = 6%*30%+18.11%*70% =	14.48%
e)	WACC with new common stock = 6%*30%+20.13%*70% =	15.89%
	CellU:
a)	Before tax cost of debt = 120/(1000*99%) =	12.12%
	Note: Bonds are assumed to be perpetual, as nothing is
	mentioned about their maturity.
	After tax cost of debt = 12.12%*(1-40%) =	7.27%
b)	Cost of preferred stock = 13/(100*95%) =	13.68%
c)	Cost of retained earnings = 2.5*1.08/18 =	15.00%
d)	Cost of new equity = 2.5*1.08/(18*85%) =	17.65%
e)	WACC with retained earnings = 7.27%*80%+13.68%*5%+15%*15% =	8.75%
f)	WACC with new common stock = 7.27%*80%+13.68%*5%+17.65%*15% =	9.15%