Question

1.    The president of Receding Airlines has asked you to calculate the company's cost of capital. To start, you have gathered the following information: RecedingAir has the following securities outstanding:

$1,000 face value, 8% annual coupon bonds with 15 years remaining to maturity and a current market price of $1,150.

$100 par value preferred stock that pays an 11% annual dividend and has a current market price of $92.

Common stock with a current market price of $50/share. Investors expect the next annual dividend to be $4.00 and to grow after that at a constant rate of 7% per year into the foreseeable future. If RecedingAir were to issue new securities today:

New bonds would pay interest annually, have a 15-year life, and incur a flotation cost of 3%.

A new issue of preferred stock would pay annual dividends and incur flotation costs of 6%

A new issue of common stock would incur flotation costs of 8%.

RecedingAir’s income is taxed at a 35% marginal rate.

RecedingAir’s target capital structure is 35% long-term debt, 15% preferred stock, and 50% common equity.

RecedingAir forecasts it will retain $25,000,000 of earnings in the coming year.

1.    What is the required rate of return of RecedingAir’s bondholders?
2.    What is RecedingAir’s cost of debt?
3.    What is the required rate of return of RecedingAir’s preferred stockholders?
4.    What is RecedingAir’s cost of preferred stock financing?
5.    What is the required rate of return of RecedingAir’s common stockholders?
6.     What is RecedingAir’s cost of retained earnings financing?
7.    What is RecedingAir’s cost of a new common stock issue?           
8.    What is RecedingAir’s weighted-average cost of capital (WACC) for its first dollar of new financing?
9.     How much total new financing can RecedingAir raise before its supply of new retained earnings financing is exhausted and there is a break in the cost of capital schedule?
10.     What would RecedingAir’s weighted-average cost of capital (WACC) become should it require more financing this year than the amount you calculated in part i, above?

Answer 1

Information Provided in question:

· 8% Bond 1000 Face Value, Maturity 15 years and Current market price 1150

· Stock 100$, Dividend 11% and current market price 92$

· Common Stock Market price 50/ share, next annual dividend 4$ and Growth Rate 7%

· New Bond have life 15-year life and Flotation cost 3%,

· New Preferred stock pay dividend annually and Flotation cost 6%

· New Common Stock incurred floatation cost 8%

Ans (A)

   Cost of Bond =   Interest/ Market Price    80/1150*100 == 6.96%

Ans(B)

   Cost of Debt = Interest of Debt/Debenture

Ans(C)

    Cost of Preferred Stock= Dividend/Current Market price   11/92*100= 11.96%

Ans(D)

    Cost of preferred stock financing= Next Dividend/ Ke- Growth Rate   4/11.96-7= 80.65

Ans(F) Cost of Retained earning

   Earning/ No of Share Holders

Ans(G) Cost of New Common Stock

Ans(H) WACC

Kd+Ke+Kp= Cost of Debt+ Cost of Equity + Cost of Preferred Stock

Ans(J)

More financing required as per calculation in part a then plus more financing amount.