Alpha Products plans to finance its capital budget for next year by selling $50

Question

Alpha Products plans to finance its capital budget for next year by selling $50 million of 11 percent coupon rate bonds, with each bond having a maturity value (M) of $1,000 and a 15-year maturity. Flotation costs (F) will be 4% of the maturity value of each bond. The balance of its $125 million capital budget will be financed with retained earnings (so that retained earnings will be at least $75 million next year). Next year Alpha expects dividends will increase at a 6.8 percent rate to $1.40 per share (so that D1 = $1.40), and the CFO expects dividends and earnings to continue growing at the 6.8 percent rate for the foreseeable future. The current market value of Alpha's stock is $28. The firm has a marginal tax rate of 35 percent. Given its flotation cost on newly issued debt what is the cost of debt for Alpha Products (rd)? What is the cost of retained earnings equity capital for Alpha Products (rs)? Finally, what is its weighted average cost of capital for the coming year (only use next year

Explanation / Answer

Answer:

Floatation cost (50000000*5%) = $                      25,00,000.00 Cost (50000000-2500000) = $                   4,75,00,000.00 Number of bonds (50000000/1000) = 50000 Pv of bond (47500000/50000) = $                                950.00 Calculating YTM = 11.65% Cost of debt = ytm*(1-tax rate) 6.99% Cost of equity = Dividend / price + growth (1.4 / 30) + 7% = 11.67% Cost of debt = 6.99% Cost of equity = 11.67% Calculating weights Value weight Debt $                   4,75,00,000.00 27.54% Equity 125000000 72.46% $                 17,25,00,000.00 WACC = weight of debt * cost of debt + weight of equity * cost of equity = 10.38%

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