Question

Valvano Publishing Company is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. Washburn, the vice-president of finance, has given you the following information and asked you to compute the weighted average cost of capital. The company currently has outstanding a bond with an 9.2 percent coupon rate and a convertible bond with a 6.2 percent rate. The firm has been informed by its investment dealer, Dean, Smith, and Company, that bonds of equal risk and credit rating are now selling to yield 10.2 percent. The common stock has a price of $66.0 and an expected dividend (D1) of $3.50 per share. The firm’s historical growth rate of earnings and dividends per share has been 5.2 percent, but security analysts on Bay Street expect this growth to slow to 8 percent in the future. The preferred stock is selling at $62 per share and carries a dividend of $4.50 per share. The corporate tax rate is 40 percent. The flotation costs are 3 percent of the selling price for preferred stock. The optimum capital structure for the firm seems to be 20 percent debt, 15 percent preferred stock, and 65 percent common equity in the form of retained earnings. a. Compute the cost of capital for the individual components in the capital structure. (Round the final answers to 2 decimal places.) Cost of capital Debt (Kd) % Preferred stock (Kp) Common equity (Ke) b. Calculate the weighted average cost of capital. (Round intermediate calculations to 2 decimal places. Round the final answers to 2 decimal places.) Weighted cost Debt (Kd) % Preferred stock (Kp) Common equity (Ke) Weighted average cost of capital (Ka) %

Answer 1

i) Cost of debt (Kd) = yield after tax

Here, yield = 10.20 or 0.1020

Tax rate = 40% or 0.40

Now,

Cost of debt (Kd) = 0.1020 * (1 - 0.40)

Cost of debt (Kd) = 0.0612 or 6.12%

Note : Coupon rate is to be ignored

ii) Cost of preferred stock (Kp) = Dividend / (Price * (1 - Flotation cost))

Here,

Dividend = $4.50

Price = $62

Flotation cost = 3% or 0.03

Now,

Cost of preferred stock (Kp) = $4.50 / ($62 * (1 - 0.03))

Cost of preferred stock (Kp) = $4.50 / $60.14

Cost of preferred stock (Kp) = 0.0748 or 7.48%

iii) Cost of common equity (as retained earnings) = (Expected dividend / Price) + growth rate

Here,

Expected dividend = $3.50

Price = $66

Growth rate (future rate) = 8% or 0.08

Now,

Cost of common equity (Ke) = ($3.50 / $66) + 0.08

Cost of common equity (Ke) = 0.1330 or 13.30%

Note : For growth rate, future rate of dividend growth is to be taken & ignore historical growth rate.

iv) Weighted average cost of capital (WACC) = (Weight of debt * Cost of debt after tax) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common equity)

Here,

Weight of debt = 20% or 0.20

Weight of preferred stock = 15% or 0.15

Weight of common equity = 65% or 0.65

Now,

WACC = (0.20 * 0.0612) + (0.15 * 0.0748) + (0.65 * 0.1330)

WACC = 0.0122 + 0.0112 + 0.0865

WACC = 0.11 or 11%