. A firm has determined its optimal capital structure, which is comprised of the

Question

. A firm has determined its optimal capital structure, which is comprised of the following sources and target market value proportions:

            Source of capital             target market proportions

            Long term debt                      30%

            Preferred stock                     5

            Common stock equity                 65

Debt: The firm can sell a 20 year, $1000 par value, 9 percent bond for $970. Interest is payable annually.

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share. The stock will pay an $8.00 annual dividend.

Common Stock: The firm’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $3.00. Its dividend payments have been growing at a constant rate of 5%.

Additionally, the firm’s marginal tax rate is 40 percent.

What is the firm’s after tax cost of debt, cost of preferred stock, cost of common stock, and the weighted average cost of capital?

Hint: Calculate the YTM for the debt, the yield on preferred stock, and the required return on the common stock. Then plug these numbers into the WACC formula.

Explanation / Answer

Cost of debt= 5.6%

Cost of preferred stock=12.9%

Cost of common stock=21.34

WACC= 0.3*5.6+0.05*12.9+0.65*21.234

           =16.2%

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