Badmmans Firearms Company has the following capital structure, which it consider

Question

Badmmans Firearms Company has the following capital structure, which it considers to be optimal: debt = 17%, preferred stock = 12%, and common equity = 71%.

Badman’s tax rate is 35%, and investors expect earnings and dividends to grow at a constant rate of 8% in the future. Badman's expected net income this year is $395,840, and its established dividend payout ratio is 24%. Badmans paid a dividend of $6.75 per share last year (D 0 ), and its stock currently sells for $96 per share. Treasury bonds yield 3%, an average stock has 10% expected rate of return, and Badmans beta is 1.75. These terms apply to new security offerings:
Common: New common stock would have a floatation cost of 16%.

Preferred: New preferred could be sold to the public at $122 per share with a dividend of $7.50. Floatation costs of $11 would be made.

Debt: Debt may be sold at an interest of 9.5%.

Find the following:

A: Component cost of debt

B: Component cost of preferred

C: Component cost of retained earnings (DCF)

D: Component cost of retained earnings (CAPM)

E: Component cost of new equity (DCF)

F: Capital budget before Badmans must sell new equity (the breakpoint)

G: WACC retained earnings

H: WACC new equity

Explanation / Answer

A. Cost of Debt = Interest(1-tax)

= 9.5%(1-0.35)

= 6.175%

B. Cost of Preferred stock = [Dividend/(MPS-Flotation Cost)]*100

= [$7.50/($122-$11)]*100

= 6.765

C. Cost of Retained earning (DCF) = [(D1/MPS)+G]*100

= [{($6.75+8%)/$96}+8%]*100

= 15.59%

D. Cost of Retained earning (CAPM) = Risk Free Return + Beta (Market Risk return - Risk Free Return)

= 3% + 1.75 (10% - 3%)

= 15.25%

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