Question

Edna Recording​ Studios, Inc., reported earnings available to common stock of

​$5,000,000

last year. From those​ earnings, the company paid a dividend of

​$1.15

on each of its

1,000,000

common shares outstanding. The capital structure of the company includes

45​%

​debt,

10​%

preferred​ stock, and

45​%

common stock. It is taxed at a rate of

30​%.

 If the market price of the common stock is

​$31

and dividends are expected to grow at a rate of

9​%

per year for the foreseeable​ future, what is the​ company's cost of retained earnings

financing​ 13.04

 If underpricing and flotation costs on new shares of common stock amount to

​$7

per​ share, what is the​ company's cost of new common stock

financing​ 14.22

The company can issue

​$1.65

dividend preferred stock for a market price of

​$35

per share. Flotation costs would amount to

​$5

per share. What is the cost of preferred stock

financing​ 5.50

The company can issue

​$1,000​-par-value, 6​%

​coupon,

14​-year

bonds that can be sold for

​$1,160

each. Flotation costs would amount to

​$25

per bond. Use the estimation formula to figure the approximate​ after-tax cost of debt​financing 3.30

 Using the cost of retained​ earnings,

r Subscript rrr​,

the​ firm's WACC,

r Subscript ara​,

is

nothing​ ?

Answer 1

a) Cost of common stock (ie cost of retained earnings) = (D1/(Price - F)) + g

Here,

g (growth) = 9% or 0.09

D1 (Expected dividend) = Dividend + growth (g)

D1 = $1.15 + ($1.15 * 9%)

D1 = $1.2535

Price = $31

F (Flotation cost) = $7

Now,

Cost of common stock = ($1.2535/($31 - $7)) + 0.09

Cost of common stock (ie. Cost of retained earnings) = 0.1422 or 14.22%

b) Cost of preferred stock = Preferred dividend / (Price of preferred stock - Flotation cost)

Cost of preferred stock = $1.65 / ($35 - $5)

Cost of preferred stock = 0.055 or 5.5%

c) Cost of debt (YTM) = (Coupon + ((P - M)/n)) / ((P + M) /2)

Here,

Par value (P) = $1,000

Market price (M) = Bond price - Flotation cost

Market price = $1,160 - $25 = $1,135

n (years) = 14

Coupon = Par value * Coupon rate

Coupon = $1,000 * 6% = $60

Now,

YTM = ($60 + (($1,000 - $1,135)/14)) / (($1,000 + $1,135)/2)

YTM = ($60 - $9.64) / $1067.50

YTM (Cost of debt) = 0.0472 or 4.72%

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

Tax rate = 30% or 0.30

After tax cost of debt = 0.0472 * (1 - 0.30)

After tax cost of debt = 0.0330 or 3.30%

d) WACC = (Weight of debt * After tax cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock)

Given,

Weight of debt = 45% or 0.45

Weight of preferred stock = 10% or 0.10

Weight of common stock = 45% or 0.45

Now,

WACC = (0.45 * 0.033) + (0.10 * 0.055) + (0.45 * 0.1422)

WACC = 0.0149 + 0.0055 + 0.0640

WACC = 0.0844 or 8.44%