Badmmans Firearms Company has the following capital structure, which it consider
ID: 2614995 • 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
1-
cost of debt
9.50%
tax rate
35%
after tax cost of debt =cost of debt*(1-tax rate)
9.5*(1-.35)
6.175
2-
cost of preferred
preferred dividend/current market price
7.5/(122-11)
0.067568
3-
cost of retained earning (Dividend discount)
(expected dividend/market price)-growth rate
(7.29/96)+.08
0.155938
expected dividend
6.75*(1.08)
7.29
market price
96
growth rate
8%
4-
cost of retained earning (CAPM)
risk free rate+(market return-risk free rate)*beta
3+(10-3)*1.75
15.25
5-
cost of new equity
(expected dividend/market price)-growth rate
(7.29/80.64)+.08
0.170402
expected dividend
6.75*(1.08)
7.29
market price
96-(1-.16)
80.64
growth rate
8%
6-capital budget
net income
395840
dividend paid
24%
95001.6
income available as retained earning
300838.4
7-
WACC
source
weight
cost
Weight*cost
debt
0.17
6.175
1.04975
preferred stock
0.12
6.765
0.8118
common stock
0.71
15.593
11.07103
WACC
sum of weight*cost
12.93
8-
WACC
source
weight
cost
Weight*cost
debt
0.17
6.175
1.04975
preferred stock
0.12
6.765
0.8118
common stock
0.71
17.04
12.0984
WACC
sum of weight*cost
13.96
1-
cost of debt
9.50%
tax rate
35%
after tax cost of debt =cost of debt*(1-tax rate)
9.5*(1-.35)
6.175
2-
cost of preferred
preferred dividend/current market price
7.5/(122-11)
0.067568
3-
cost of retained earning (Dividend discount)
(expected dividend/market price)-growth rate
(7.29/96)+.08
0.155938
expected dividend
6.75*(1.08)
7.29
market price
96
growth rate
8%
4-
cost of retained earning (CAPM)
risk free rate+(market return-risk free rate)*beta
3+(10-3)*1.75
15.25
5-
cost of new equity
(expected dividend/market price)-growth rate
(7.29/80.64)+.08
0.170402
expected dividend
6.75*(1.08)
7.29
market price
96-(1-.16)
80.64
growth rate
8%
6-capital budget
net income
395840
dividend paid
24%
95001.6
income available as retained earning
300838.4
7-
WACC
source
weight
cost
Weight*cost
debt
0.17
6.175
1.04975
preferred stock
0.12
6.765
0.8118
common stock
0.71
15.593
11.07103
WACC
sum of weight*cost
12.93
8-
WACC
source
weight
cost
Weight*cost
debt
0.17
6.175
1.04975
preferred stock
0.12
6.765
0.8118
common stock
0.71
17.04
12.0984
WACC
sum of weight*cost
13.96
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