Best Dairy (“BD”), Inc.is constructing its cost of capital. Its target capital s
ID: 2596194 • Letter: B
Question
Best Dairy (“BD”), Inc.is constructing its cost of capital. Its target capital structure is 30 percent debt and 70 percent common equity. It can raise up to $15.0 million in bank loans at a before tax cost of 10% but any debt beyond $15.0 million will have a higher cost at 13% before tax. BD is a constant growth firm that just paid a common stock dividend of $3.40, the common stock currently sells for $50.00 per share and has a constant growth rate of 6 percent. The firm's available retained earnings are expected to be $9 million. Flotation costs on new common stock total $3.00 per share. The new shares of common stock will have to be underpriced by $2.50 per share to sell. The firm's marginal tax rate is 40 percent.
a. Calculate the after tax cost for each of the capital components.
b. Calculate all Breakpoints.
c. Draw the graph, label all elements (i.e., label each tier, the breakpoints, etc.)
d. Calculate the weighted cost of capital for each tier of financing.
Explanation / Answer
1. Calculation of after tax cost of capital of each capital component.
Debt (30%) :
Before tax cost of debt upto $15 Million = 10%
After tax cost of debt upto $15 million = 10%(1- Tax rate) = 10%(1-0.40) = 6.00%
Cost of Debt before tax over $15 Million = 13%
Cost of Debt after tax over $15 Million = 13%(1- Tax Rate) = 13%(1-0.40) = 7.8%
Retained Earnings:
Cost of Retained earnings = D1 / P0 + G
where D1 is the amount of dividend to be paid next(Inclusive of growth)
P0 is the current market price per share
G is the growth rate
Cost of Retained earnings = D0(1+g) / P0 + g
= 3.4 (1+6%) / $50 + 6% = 13.208%
Equity:
Cost of Equity = D1 / (P0 - F) + g
Where D1 is the amount of dividend to be paid next(Inclusive of growth)
P0 is the current market price of share
F is the floatation cost
g is the growth rate
Cost of Equity = 3.4(1+6%) / (50 - 3) + 6%
= 13.67%
2. Calculation of Breakpoints
Breakpoint of Debt = Total Debt Available at lower rate / Percentage of debt in company
= 15 Million / 30% = $50 Million
Breakpoint in retained earnings = Total Retained earnings available / Percentage of equity
= 9 Million / 70% = $12.857 Million
3. Calculation of WACC.
If total amount of capital required is $50 Million, then WACC will be
Total WACC = 1.8% + 3.40% + 6.054% = 11.254%
Capital Component After tax cost Debt (upto 15 Million) 6% Debt (Above 15 Million) 7.8% Retained Earnings 13.208% Equity 13.67%Related Questions
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