Droz\'s Hiking Gear, Inc. has found that its common equity capital shares have a
ID: 2744254 • Letter: D
Question
Droz's Hiking Gear, Inc. has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 % and the expected return on the market is 14 %. It has 7-year semiannual maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 %. It has preferred stock that sells for $25 and pays a dividend of $4. The firm is financed with $120,000,000 of common shares (market value), $45,000,000 of preferred stock, and $80,000,000 of debt. What is the after-tax cost of capital for Droz's, if it is subject to a 35 % marginal tax rate?
Explanation / Answer
First, Let us calculate the return on equity:
Return on equity (Ke)= Rf + (Rm – Rf)
= 8% + (14%-8%) 1.5
= 8% + 9%
= 17%
Kd = Interest × (1-Tax rate)
= 7% × (1-0.35)
= 4.55%
Kp = Preference dividend / Preferred stock
= $4 / $25
= 16%
Now, after tax cost of capital of DHG is computed as follows:
Source of capital
Amount
Weight
Cost
WACC
Equity capital (common stock)
$ 120,000,000
0.490
17%
8.3%
Preference capital
$ 45,000,000
0.184
16%
2.9%
Debt
$ 80,000,000
0.327
5%
1.5%
$ 245,000,000
12.8%
Therefore, after tax cost of capital is 12.8%.
Source of capital
Amount
Weight
Cost
WACC
Equity capital (common stock)
$ 120,000,000
0.490
17%
8.3%
Preference capital
$ 45,000,000
0.184
16%
2.9%
Debt
$ 80,000,000
0.327
5%
1.5%
$ 245,000,000
12.8%
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