Question

Brook’s Window Shields Inc. is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. Glass, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with a 9.2 percent coupon rate and another bond with a 6.2 percent coupon rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 10.2 percent.

The common stock has a price of $66 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 Wall Street expect this growth to slow to 3 percent in future years.

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 cost is 1.8 percent of the selling price for preferred stock. The optimal capital structure is 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. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

b. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

Answer 1

a

Proceeds from preferred equity = price*(1-flotation cost) = 62*(1-0.018)=60.884

Cost of equity

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

66 = 3.5/ (Cost of equity - 0.03)

Cost of equity% = 8.3

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 10.2*(1-0.4)

= 6.12

cost of preferred equity

cost of preferred equity = Preferred dividend/proceeds*100

cost of preferred equity = 4.5/60.884*100

=7.39

b

Weight of equity = E/A

Weight of equity =

W(E)=0.65

Weight of debt = D/A

Weight of debt = 0.2

W(D)=0.2

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.2 - 0.65

W(PE)=0.15

Weighted cost of equity = weight of equity*cost of equity

=5.4

Weighted cost of preferred equity = weight of preferred equity*cost of preferred equity

=1.11

Weighted cost of debt= weight of debt*cost of debt

=6.12*0.2=1.22

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=6.12*0.2+8.3*0.65+7.39*0.15

WACC =7.73%