Management has concluded that the best combination of capital sources is as foll

Question

Management has concluded that the best combination of capital sources is as follows:debt,45% and common equity,55%. Investment bankers have informed management that 20-year, $1000 par value, debt with a coupon rate of 9% (annual payment) can be sold to investors at par. Flotation costs on such debt is expected to be 6% of the market value of the debt issued. Common stock currently sells for $50 per share. The current expected rate of return required by stockholders is 14%. The long term investors expected growth rate in earnings per share and dividends per share is 4%. Flotation costs on any sales of common stock are estimated to be 8% of the market value od the equity issued. Assume that common stock must be sold to raise sufficient equity to finance the firms expected expansion in assets and that the firm is subject to a 35% tax rate. What is the firms marginal weighted average cost of capital? Show your work.

Explanation / Answer

Say, the company wants to raise $ 1 billion.

Since targeted debt (D) is 45% and common equity (E) is 55%,

D = $ 450,000,000

E = $ 55,000,000

Since interest on bond will be paid annually, the interest will not be compounded.

Since floatation cost of debt is 6% and coupon rate of bond is 9%, therefore cost of debt

Kd = 9% / (1 – 6%) = 9.57%

Current expected rate of return on equity (k) = 14%

Dividend per share (d) = 4%

Therefore, effective rate of return on equity = k/ (1 - d) = 14.58%

Since floatation cost of equity is 8%, therefore cost of equity

Ke = 14.58% / (1 – 8%) = 15.85%

Tax rate (T) = 35%

Finally, weighted average cost of capital (C) = E x Ke / (D + E) + D x Kd x (1 – T) / (D + E)

Therefore, WACC = 11.52%

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