You are provided the following information on a company. The total market value

Question

You are provided the following information on a company. The total market value is $40 million. The capital structure, shown here, is considered to be optimal.


Accounting Value Market Value

Bonds, $1000 par, 5% coupon, 4% YTM $10,000,000 $10,000,000
Preferred Stock, 5%, $100 par, 100,000 shares $10,000,000 $8,000,000
Common Stock, $1 par, 100,000 shares $100,000
Capital in excess of par $400,000 $22,000,000 *
Retained Earnings $13,500,000

* Total market value of common equity


a. What is the after-tax cost of debt? (assume the company

Explanation / Answer

a. What is the after-tax cost of debt? (assume the company’s effective tax rate = 40%) Debt is Bonds whose coupon is 5% So After Tax Cost of debt = Kd(1-t) = 5%*(1-40%) = 3% b. Assuming a $5 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = $0.00) Mkt Value of pref stock is $8,000,000/100,000 = $80 So Return on Pref stock = Pref Div/Mkt price = $5/$80 = 6.25% c. Assuming the risk-free rate is 2%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)? Cost of Equity Ke = Krf + Beta*(Rm-Rf) = 2% + 1.0*(7%-2%) = 7% d. What is the company's weighted average cost of capital (WACC)? Total Capital = Bonds + Pref Cap + Common euity = 10,000,000+8,000,000+22,000000 = $40,000,000 So Wd = Wight of Debt = 10,000,000/40,000,000 = 25% Wp = eight of Pref cap = 8,000,000/40,000,000 = 20% We = weight of equity = 22,000,000/40,000,000 = 55% Weighted average cost of capital (Ka) WACC (Ka)= Wd*(Kd)*(1-t)+(Wp)*(Kp) +(We)*(Ke) where Wd= The proportion of the financing taken on by debt=25% Wp= The proportion of the financing taken provided by preferred stock=20% We= The proportion of the financing provided by equity=55% Kp= 6.25% Kd=5% Ke = 7% So WACC (Ka) = Wd*(Kd)*(1-t)+(Wp)*(Kp) +(We)*(Ke) ie wacc = 25%*5%*(1-40%) + 20%*6.25% + 55%*7% = 5.85%

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