Question

Q2: Firm AAA wants to issue bonds with a 5% coupon rate, a face value of $1,000, and 5 years to maturity. Firm AAA estimates that the bonds will sell for $1,080 and that flotation costs will equal $10 per bond. Firm AAA common stock currently sells for $30 per share. Firm AAA can sell additional shares by incurring flotation costs of $2.5 per share. Firm AAA paid a dividend yesterday of $4.00 per share (D0=4) and expects the dividend to grow at a constant rate of 5% per year. Firm AAA also expects to have $12 million of retained earnings available for use in capital budgeting projects during the coming year. Firm AAA 's capital structure is 30% debt and 70% common equity. Firm AAA’s marginal tax rate is 35%. a). Assuming Firm AAA 's bonds are its only debt, its after-tax cost of debt is__________. b). The cost of retained earnings is ________. c). The cost of new common stock is_________ d). Assuming firm AAA's total capital budget is $50 million, its WACC is________.

Please explain how you calculated the answer.

Answer 1

A	B	C	D	E	F	G	H	I
2		a)
3		Calculation of after-tax cost of debt:
4		Cost of debt will be the yield to maturity of the bond can be calculated as follows:
5		Time to maturity	5	years
6		Annual coupon rate	5.00%
7		Par value	$1,000
8		Market Price	$1,080
9		Annual coupon	$50	=D7*D6
10		Annual Period	5	=D5
11		Floatation cost	$10
12		Net proceed by issuing bond	$1,070	=D8-D11
13		Rate(nper,pmt,PV, [fv],type) function of excel can be used to find the yield to maturity as follows:
14		NPER	5
15		PMT	$50
16		PV	$    (1,070.00)
17		FV	$1,000
18
19		Yield to maturity of the bond	3.45%	=RATE(D14,D15,D16,D17)
20
21		Hence Cost of debt is	3.45%
22
23		Tax rate	35%
24
25		After Tax cost of debt	=Cost of debt*(1-Tax rate)
26			=3.45%*(1-35%)
27			2.24%	=D21*(1-D23)
28
29		Hence After Tax cost of debt	2.24%
30
31		b)
32		In the calculation of cost of retained earnings, floatation cost will be ignored,
33		as stocks are not issued in the market.
34		Cost of retained earnings can be calculated as below:
35		Dividend This Year (Div 0)	$4.00
36		Price	$30
37		Growth rate	5%
38
39		From Dividend growth model,
40		r(E) = (Div0*(1+g)/P)+g
41
42		Cost of retained earnings=	19.00%	=(D35*(1+D37)/D36)+D37
43
44		Hence cost of retained earnings is	19.00%
45