Your firm is considering a new investment proposal and would like to calculate i

Question

Your firm is considering a new investment proposal and would like to calculate its weighted average cost of capital. To help in this, compute the cost of capital for the firm for the following:

a. A bond that has a $1000 par value (face value) and a contract or coupon interest rate of 12.9 percent that is paid semiannually. The bond is currently selling for a price of $1129 and will mature in 10 years. The firm's tax rate is 34 percent.

b. If the firm's bonds are not frequently traded, how would you go about determining a cost of debt for this company?

c. A new common stock issue that paid a $1.71 dividend last year. The par value of the stock is $14 , and the firm's dividends per share have grown at a rate of 7.4 percent per year. This growth rate is expected to continue into the foreseeable future. The price of this stock is now $28.58.

d. A preferred stock paying a 9.7 percent dividend on a $120 par value. The preferred shares are currently selling for $ 153.66.

e. A bond selling to yield 12.8 percent for the purchaser of the bond. The borrowing firm faces a tax rate of 34 percent.

Explanation / Answer

a) YTM using an online financial calculator = 10.76% After tax cost of debt = 0.1076*(1-0.34) = 7.10% b) The bond could be rated by a credit rating agency and the cost of it could be determined by adding a premium for the risk. The base cost can be that of bonds with similar rating. The premium should of lack of liquidity among other things. c) Cost of equity = D1/[P0*(1-f)]+g Where D1 = next expected dividend P0 = Current price f = floatation cost g = growth rate Substituting values, cost of equity = 1.71*1.074/28.58+0.074 = 13.83% d) Cost of preferred stock = 120*9.7%/153.66 = 7.58% e) Cost of debt = 0.128*(1-0.34) = 8.45%

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