Question

Company issues bonds at a price of $925 and a flotation cost of 1%.

The bond has an annual coupon rate of 5% and a maturity of 10 years.

The corporate tax rate is 40%.

Common stock sells at $30 per share and new issues would have a flotation cost of $2.

The last dividend paid was $3 per share and the growth rate of dividends is 6%.

Your firm’s capital structure is 20% debt, 20% retained earnings, and 60% common stock.

1. Compute the after-tax cost of debt
2. Compute the cost of common stock
3. Compute the cost of retained earnings
4. Compute the Weighted Average Cost of Capital

Answer 1

a

Proceeds from bonds

= Price*(1-flotation percentage)

=925*(1-0.01)=915.75

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

915.75 =∑ [(5*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM% = 6.15

After tax rate = YTM * (1-Tax rate)

After tax rate = 6.15 * (1-0.4)

After tax rate = 3.69

b

Proceeds from equity offering per share = price-flotation charges

=30-2 = 28

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

28 = 3 * (1+0.06) / (Cost of equity - 0.06)

Cost of equity% = 17.36

c

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

30 = 3 * (1+0.06) / (Cost of equity - 0.06)

Cost of equity% = 16.6

d

WACC=after tax cost of debt*W(D)+cost of equity*W(E) + cost of retained earnings *weight of retained earnings

=3.69*0.2+16.6*0.2+17.36*0.6= 14.474%