A.) Assume the following capital structure for Morgan Corp. Debt: 35% Preferred
ID: 2759135 • Letter: A
Question
A.) Assume the following capital structure for Morgan Corp.
Debt: 35%
Preferred Stock: 15%
Common Equity: 50%
The following facts are also provided:
Bond yield to maturity: 9%
Corporate tax rate: 35%
Dividend, preferred stock: $8.50
Price, preferred stock: $100
Flotation cost, preferred stock: $2
Divident, common stock: $1.20
Price, common stock: $30
Growth Rate, common stock: 9%
Compute the weighted average cost of capital.
B.) If there is $30 million in retained earnings, at what dollar value will the marginal cost of capital go up? If flotation cost on common stock is $1.50, what will be the cost of the new common stock?
Show all work please. Thank you!
Explanation / Answer
Solution:
A)
Cost of Debt (after tax) (Kd) = Bond Yield to maturity (1 – Tax Rate) = 9% (1-0.35) = 5.85%
Cost of Preferred Stock (Kp) = Preference Dividend / Net Proceed x 100 = $8.50 / $98 x 100 = 8.673%
Net Proceed = Issue Price – Floatation Cost = $100 - $2 = $98
Cost of Equity (Ke) = D1 / Net Proceeds + growth rate = ($1.20 x 1.09) / $30 + 0.09 = 0.0436 + 0.09 = 0.1336 or 13.36%
Weighted Average Cost of Capital = Kd.Wd + Kp.Wp + Ke.We = (5.85% x 0.35) + (8.673% x 0.15) + (13.36% x 0.50)
= 2.0175% + 1.30095% + 6.68% = 9.998% or 10%
W ---- means weight in capital structure..
B)
If there is $30 million in retained earnings, it means it will be equal to 50% of total capital structure.
I.e. Total Amount which can be available with the company = $30 million / 50% = $60 Million
Marginal Cost of Capital go up beyond $60 Million.
New Cost of Common Stock = D1 / Net Proceeds + growth rate = ($1.20 x 1.09) / $28.50 + 0.09 = $1.308 / $28.50 + 0.09 = 0.04589 + 0.09 = 0.13589 or 13.59% or 13.60%
Net Proceeds = Issue Price – Floatation Cost = $30 - $1.50 = $28.50
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