The balance sheet that follows indicates the optimum capital structure for Nealo

ID: 2717039 • Letter: T

Question

The balance sheet that follows indicates the optimum capital structure for Nealon Inc. Flotation costs are (a) 3% of market value for a new bond issue, and (b) $1.00 per share for preferred stock. The dividends for common stock were $2.50 last year, ten years ago the dividends were $1.40 per share. The firm is in a 34 percent tax bracket. What is the weighted average cost of capital if the firms finances are in the following proportions?

Bonds (8%, $1,000 par, 26-year maturity) ------------------- 40%

Preferred Stock (5,000 shares outstanding, $50 par, $1.50 dividend) ------------------------ 10%

Common Equity ($1 par) market value $35 -------------------------- 50%

1. Market prices are $1,135 for bonds, $19 for preferred stock, and $35 for common stock.

2. Flotation costs of bonds up to $2,000,000 of bonds is 3%.

3. More than $2M, the flotation cost increases to 6%.

4. The company would obtain the first $1,000,000 of equity from retained earnings.

5. Equity above $1M would be obtained from the sale of new common stock. (7% flotation cost).

a. Calculate the component cost of each type of capital.

b. Calculate the $ levels at which the cost of capital would change.

c. And calculate the WACC at each level.

Explanation / Answer

Answer: Calculation of the WACC:

Cost of Debt:

$1,135 (1 - .03) = $1100.95 = NP0

$1100.95=80/(1+Kd)t+1000/(1+Kd)26

Kd=7.139%

After-tax cost of debt = 7.139% (1 - .34)

= 4.71174%

Cost of Preferred Stock:

kps = D/NP

=$1.50/($19-$1)=8.33%

Cost of Internal Common Funds:

Ke=($2.50*(1+0.06)/$35)+0.06

=13.57%

Weighted Cost of Capital (K wacc) using internal common funds only:

Weights

Costs

Weighted Costs

Bonds

0.40

4.71174%

1.884696%

Preferred Stock

0.10

8.33%

0.833%

New Common Stock

0.50

13.57%

6.785%

1.00

9.50%