A firm has determined its optimal capital structure which is composed of the fol

Question

A firm has determined its optimal capital structure which is composed of the following sources and target market calve proportions. Debt: The firm can sell a 12-year, 31,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at S75 per share par value. The stock will pay a $I.0 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for SIX per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue most be underpriced SI per share in floatation costs. Additionally, the firm's marginal tax rate. is 40 percent. Calculate the following: The firm's before-tax cost of debt The firm's after-tax cost of debt The firm's cost of preferred stock The firm's cost of a new issue of common stock The firm's cost of retained earnings The weighted average cost of capital

Explanation / Answer

1. The before tax cost of debt is equal to YTM which is equal to 8%.

    This is calculated in excel using N = 12 years, PV = $940.00 (Face value – discount –

    floatation cost), PMT = -$70.00 and FV = -$1,000.00

2. The after tax cost of debt is equal to 8%*(1 - 0.40) = 4.80%.

3. The cost of preferred stock is

Dividend/(Price of share – cost of issue) = $10/($75 - $3) = 13.89%

4. Cost of a new issue of common stock

(Dividend/Price – Floatation cost) + Growth Rate = ($1.74/$18.00 – $1) + 4 = 14.24%

5. Cost of Retained Earnings is same as the cost of Equity hence 14.24%

6. Weighted Average Cost of Capital = 0.20*4.80 + 0.10*13.89 + 0.70*14.24

                                                                  = 0.96 + 1.39 + 9.97 = 12.32%

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