Badmmans Firearms Company has the following capital structure, which it consider
ID: 2614807 • Letter: B
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) Component cost of debt = 9.5*(1-0.35) = 6.18% B) Component cost of preferred = 7.5/(122-11) = 6.76% C) Component cost of retained earnings (DCF) = 6.75*1.08/96+0.08 = 15.59% D) Component cost of retained earnings (CAPM) = 3+1.75*(10-3) = 15.25% E) Component cost of new equity (DCF) = 6.75*1.08/(96*84%)+0.08 = 17.04% F) New equity break point = 395840/0.71 = $ 5,57,521 h) WACC Retained earnings = 6.18*17%+6.76*12%+15.42*71% = 12.81% [Cost of retained earnings = (15.59+15.25)/2 = 15.42%] i) WACC with new equity = 6.18*17%+6.76*12%+17.04*71% = 13.96%
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