Show work and explain please for lifesaver... Crow Corporation is planning a $20

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Show work and explain please for lifesaver...

Crow Corporation is planning a $200 million expansion to be financed with debt, preferred stock and common stock. Their target capital structure includes 20% debt and 5% preferred stock.They have $30 million in retained earnings and will raise the rest of the funds by issuing common stock. They plan to raise funds to match the target capital structure.The tax rate is 40%.

Bonds: Crow Corporation has bonds with 6 years to maturity and a face value of $1000. The coupon rate is 7.8% and coupons are paid semiannually. The bonds trade at $990 per bond.     

Preferred Stock: Crow issues preferred stock with a $2.85 dividend per year. They are sold to the market at $27 per share, but issue costs are $2 per share.

Retained Earnings: Crow uses the capital asset pricing model (CAPM) to estimate this. The firm has a beta of .95. The risk-free return is 4% and the market risk premium is 10%

Common Stock: Crow has a current dividend of $2.40. The payout rate is 60% and return on equity (ROE) is 20%. The price of the common stock after issue costs is $36 per share.  

Calculate the weighted average cost of capital (WACC). Carry work out to 4 decimal places. The expansion is expected to produce cash flows of $48,000,000 every year for the next 6 years. Use the WACC to find the net present value (NPV).   

Should they expand? Explain. Show work and explain please for lifesaver...

Explanation / Answer

Weighted average cost of capital (WACC) is the proportional average of each category of capital-common stock, preferred stock, bonds, etc. It is, thus, important to note that WACC is impacted by:

a. Cost of each category of capital

b. Respective proportion of each category in the total capital structure.

In the given case, the company has common stock, bonds, preferred stock and retained earnings. Before finding WACC, it is necessary to compute individual cost of capital of each category.

1. Cost of debt = RD * (1 - tax rate)

To find cost of debt, we have to understand the cashflows of bond buyer/holder (Because in the given case coupon is paid semi-annually else annual rate of interest on the bond is its cost of capital)

For a person to buy bonds, his cashflows would be:

a. Invest $ 990 to buy the bond

b. Earn semi-annual interest on the face value of the bond over its life, i.e., 7.8%/2 = 3.9% per half year over the remaining 6 years (6*2=12 half years). Thus, earnings would be 3.9% * $ 1000 = $ 39 per half year over 12 half years

c. Get $ 1,000 on redemption

We need to find effective rate of interest 'r' for the bond-holder using the cash flow details above.

The price paid today = PV of interest received in annuity over 12 half years + PV of $ 1000 received at the end of 12 half years

$ 990 = $ 39 * PVIFA(r %,12) + $ 1000 * PVF (r%,12)

Using trial and error, r = 4%

Thus r = 4 % is earned per half year and not 7.8%/2 = 3.9% (That is a common gap in understanding)

Since cost of debt is earned per annum, RD = 2 * 4% = 8%

Thus after-tax cost of debt = 8% * (1-40%) = 4.80%

2. Cost of preferred stock (RPS) = Dividend to preferred stockholders

Net issue price of preferred stock

In the given question, dividend earned is $ 2.85.

Net issue price of preferred stock is arrived by reducing floatation costs from the current selling price. Thus, net issue price of preferred stock is the amount that the company eventually gets by issuing preferred stock. In the given case net issue price of preferred stock is $ 27- $2= $25

Putting the two values in the equation,

RPS = $ 2.85/ $ 25 = 11.40%

Please note that before-tax cost of preferred stock = After-tax cost of preferred stock

3. Cost of retained earning (RRE)= Rf + Beta * Market premium

Where Rf is the risk-free rate of return

In the given question,

RRE = 4% + 0.95 * 10%

     = 13.50%

4. Cost of common stock (RCS)= D1 / P0 + g

where D1 = Next period annual dividend

P0 = Current stock price

g = Dividend growth rate or RE*(1

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