Delta Chemical Corporation is expected to have the following capital structure f

Question

Delta Chemical Corporation is expected to have the following capital structure for the foreseeable future.

The flotation costs are already included in each cost component. The marginal income tax rate (tm) for Delta is expected to remain at 40% in the future.

1. Determine the cost of capital (k).

2. If the risk freerate is known to be 6% and te average return on S&P 500 is about 12%, determine the cost of equity with Beta= 1.2 based on the capital asset pricing model.

3. Determine the cost of capital on the basis of cost of equity obtained in b.

Sources of After-Tax Financing % of Total Funds Before-Tax Cost Cost Debt 30% Short Term 10% 14% Long Term 20% 12% Equity 70% Common Stock 55% 30% Preferred Stock 15% 12%

Explanation / Answer

1)

cost of capital = 0.1 * 14% * (1-0.4) + 0.2 * 12% * (1-0.4) + 0.55 * 30% + 0.15 * 12%

= 20.58%

2)

cost of equity = 6% + 1.2 * (12% -6%) = 13.2%

3)
cost of capital = 0.1 * 14% * (1-0.4) + 0.2 * 12% * (1-0.4) + 0.55 * 13.2% + 0.15 * 12%

= 11.34%

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