Lang Enterprises is interested in measuring its overall cost of capital. Current

Question

Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket.

DebtThe firm can raise debt by selling $1000 par value, 9% coupon interest rate, 15 year bonds on which annual interest payments will be made. To sell the issue, an average discount of $20 per bond would have to be given. The firm also must pay flotation costs of $ 35 per bond.

Preferred stockThe firm can sell 8.5% preferred stock at its $105 per share par value The cost of issuing and selling the preferred stock is expected to be $7 per share. Preferred stock can be sold under these terms

Common stockThe firm's common stock is currently selling for $60 per share. The firm expects to pay cash dividends of $4.5 per share next year. The firm’s dividends have been growing at an annual rate of 9% and this growth is expected to continue into the future. To sell new shares of common stock, the firm must underprice the stock by $7 per share, and flotation costs are expected to amount to $3 per share. The firm can sell new common stock under these terms.

Retained earningsWhen measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $150,000 retained earnings in the coming year r; once these retained earnings areexhausted, the firm will use new common stock as the form of common stock equity financing.

a.Calculate the after-tax cost of debt.

b.Calculate the cost of preferred stock.

c.Calculate the cost of common stock.

d.Calculate the firm's weighted average cost of capital using the capital structure weights shown in the following table,

Long-term debt,40%

Preferred stock,20%

Common stock equity,40%

Total,100%

Explanation / Answer

(a) Computation of the after-tax cost of debt.We have,

Before tax cost of debt = [I + 1/n(P - NP)] / 1/2(P + NP)

Where,

I = Coupon rate = 1,000 x 9% = $ 90

n = Number of years = 15 years

P = Proceeds at par = $ 1,000

NP = Net proceeds = 1,000 - 20 - 35 = $ 945

Before- tax cost of debt = [90 + 1/15 ( 1,000 - 945)] / 1/2(1,000 + 945)

Before- tax cost of debt = 93.67 / 972.50 = 9.63 %

After tax cost of debt = Before-tax cost of debt x ( 1 - tax rate)

After- tax cost of debt = 9.63% (1 - 0.40) = 5.78 %

(b) Computation of the cost of preferred stock.We have,

Cost of preferred stock = Dividend / Net proceed

Cost of preferred stock = (100 x 8.5%) / (105 - 7)

Cost of preferred stock = 8.5 / 98 = 0.0867 * 100 = 8.67 %

(c) Computation of the cost of common stock.We have,

Using the dividend valuation model.We have,

Price of stock = Expected dividend / ( Cost of equity - growth rate)

60 - 7 - 3 = 4.50 / ( Cost of equity - 0.09)

Cost of equity - 0.09 = 4.50/ 50 = 0.09

Cost of equity = 0.09 + 0.09 = 0.18*100 = 18%

(d) Computation of the firm's weighted average cost of capital(WACC).We have,

WACC = 0.40 X 5.78 + 0.20 X 8.67 + 0.40 X 18

WACC = 2.31 + 1.73 + 7.2 = 11.24%

Hence,the firm's weighted average cost of capital(WACC) is 11.24%.

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