Question

18. You are evaluating next year investment opportunities and your company cost of capital. You anticipate that if you could minimize your cost, more feasible projects could be undertaken. You are also able to determine your capital budget for next year. Opportunities available are as follows:

Projects Rate of Return

1. A 13%

2. B 12%

3. C 15%

4. D 14%

5. E 11%

You believe your current capital structure is optimal and even if you would have to raise new funds, this proportion will be maintained:

LT Debts 50% Pref. Stock 10% Com. Stock 40%

Your company can issue unlimited amount of 9% semi-annual coupon bond with 10 years maturity period. Bonds will be issued at par but a 2.5% flotation cost will be incurred.

You can sell new 9% $100 par value preferred stock for $95 per share. Flotation cost is $10 per share.

Forthcoming dividend is expected to be $1.25, dividend expected to grow at a constant rate of 4% and common shares is selling for $11. The company expects $320,000 in retained earnings and cost of issuing new common stock is $1.00. Your tax rate is 40%.

Which investment/s, if any, would you recommend? Use the WMCC/IOS to explain.

(Hint: Determine the following: Cost of capital components; Breakpoints; WACC at various level of breakpoints; Projects accepted and total amount of capital budget; WACC for the planning period)

Answer 1

The cost of capital is comprised of the costs of debt, preferred stock, and common stock. The formula for the cost of capital is comprised of separate calculations for all three of these items, which must then be combined to derive the total cost of capital on a weighted average basis.

The formula for the cost of debt is as follows:

=       (Interest Expense x (1 – Tax Rate) ÷
Amount of Debt – Debt Acquisition Fees + Premium on Debt – Discount on Debt

The cost of preferred stock is as follows:

=       Interest Expense ÷ Amount of Preferred Stock

The formula for the cost of common stock is as follows:

Risk-Free Return + (Beta x (Average Stock Return – Risk-Free Return)

Once all of these calculations have been made, they must be combined on a weighted average basis to derive the blended cost of capital for a company.

Total Debt Funding                       x        Percentage Cost       =       Dollar Cost of Debt

Total Preferred Stock Funding         x        Percentage Cost       =       Dollar Cost of Preferred Stock

Total Common Funding                 x        Percentage Cost       =       Dollar Cost of Common Stock

                                                                                        =       Total Cost of Capital

Weighted Average Cost of Capital

With the above options in mind, the weighted average cost of capital (WACC) normalizes the cost of capital by combining the interest rates being incurred from both debt and equity. It can be written as:

WACC=D/D+E*Kd+E/D+E*Ke