You are planning a capital budget of $30 million. Your capital structure which y
ID: 2737317 • Letter: Y
Question
You are planning a capital budget of $30 million. Your capital structure which you feel is optimal, is 60% debt and 40% equity. This firm does not use preferred stock financing. The firm's marginal tax rate is 35%.
Currently your common stock sells for $26 in the market and the current dividends is $2.00 per share. Your investment banker will charge you a 10% flotation cost to sell new shares of common stock. Currently investors anticipate a 9% growth rate for the division and earnings of the firm.
The debt portion of your budget will come from a bond issuance. The investment banker thinks bonds can be sold into the market with a yield to maturity of 12%.
What is the cost of capital (after taxes) for the debt of this project?
What is the cost of capital for new equity (common stock) for this project?
What is the cost of capital for retained earnings for this project?
If all equity capital come from Retained Earnings, what is the firm’s weighted average cost of capital (WACC)?
Explanation / Answer
Answer: cost of capital after tax debt=Kd (1-tax)
=12% (1-0.35)
=7.8%
Answer: cost of capital for new equity (common stock):
Ke=[$2(1.09)/($26-($26*10%))]+0.09
=18.32%
Answer: cost of capital for retained earnings :
Ke (retained earnings)=$2(1.09)/$26+0.09
=17.38%
Answer: WACC=0.60*7.8%+0.40*17.38%
=4.68%+6.952%
=11.632%
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