Question

The current capital structure of stewart-line corporation is as follows:

Bonds (7 %, $1000 par 15 years)                 $75,000

Preferred stock ($100 par, 7.25% dividend)          $1,000,000

Common stock:

Par value ($2.50 par)                       $500,000

Retained earnings                           $350,000 $850,000

Total $ 2,600,000

Other information about Stewart-line corporation:

The market price is $975 for the bonds, $60 for the preferred stock, and $21 for common stock. Flotation costs are 9% for bonds and 5% for preferred stock. The firm’s tax rate is 46%. Common stock will pay a $2.80 dividend which is not expected to grow.

a. Calculate the weighted cost of capital using only internal common equity

b. Why do we need to determine the firm’s overall weighted cost of capital and not just the individual component cost of capital?

Answer 1

	COMPONENT COST OF CAPITAL:
1)	Before tax cost of debt = YTM. YTM using an online calculator =	8.35%
	Inputs for YTM:
	Price = 975-975*9% = $887.25, n = 15, coupon rate = 7%]
	After tax cost of debt = YTM*(1-t) = 8.35%*(1-46%) =	4.51%
2)	Cost of preferred stock = 7.25/(60-60*5%) =	12.72%
3)	Cost of retained earnings = 2.80/21 =	13.33%
a)	WACC:
	Component	Market Value	Weight	Component Cost	WACC
	Debt (75000*975/1000)	73125	1.50%	8.35%	0.13%
	Preferred stock (1000000*60/100)	600000	12.31%	12.72%	1.57%
	Common stock (retained earnings) (500000*21/2.5)	4200000	86.19%	13.33%	11.49%
	Total	4873125	100.00%		13.18%
	WACC = 13.18%
b)	The component cost of capital gives the cost of a particular source of capital from the firm's point of view. Thus,
	a firm would have to calculate cost of debt, cost of preferred stock, cost of retained earnings and cost of new
	equity. But, these individual costs represent the required return associated with the cash flows of the component
	sources of capital only, including the risk involved.
	But, as a firm raises capital from all or a combination of the above sources, the weighted average cost of those
	sources of capital is required to determine the required return of the projects in which the firm employs those
	funds, consistent with its overall risk. Hence, component cost alone is not enough; what is required is the WACC.