You develop the following information. Your firm has a target capital structure

Question

You develop the following information. Your firm has a target capital structure of 80% common equity, 5% preferred stock and 15% debt. The firm’s tax rate is 25%.

The firm can issue up to $225,000 worth of debt at a before-tax cost of 10%. Then it will cost the firm 11.5% before-tax on debt up to $300,000. After that point, the after-tax cost of debt will be 9.75%.

The firm’s preferred stock carries an annual dividend of $1.75 per share. The issue price of the preferred would be $20 with 2% of the issue price charged as flotation costs. The firm can use up to $125,000 of this preferred stock before the cost will increase to 10%.

The firm expects to have $1,500,000 in earnings and have a dividend payout ratio of 30%. The firm bases its cost of retained earnings on the CAPM approach. For this purpose, you determine the growth rate of the market will be 6% and the market dividend yield is 8%. The risk-free rate is 2.50%. The firm’s beta is 0.80.

The firm can issue new common stock with a $1.00 dividend, price of $25 per share, flotation costs of 4% of issue price and growth rate expected of 8%. This holds for up to $1,400,000 in equity after which it will cost 13% for new common stock.

Determine the marginal cost of capital schedule.

(show work please)

Explanation / Answer

1- Cost of Retained Earning

Market Return = Yield+Growth rate

= 8%+6%= 14%

CAPM (Kr) = Rf+Beta (Rm-Rf)

= 2.50% + 0.80(14-2.50) = 11.70%

Cost of Retained Earning =11.70%

Dividend Payout = $1500000*30%= $450000

Retained Earning= $1500000-$450000 =$1050000

2- Cost of Equity (Common Stock)

Next Dividend= $1.00

Issue Price (after Flotation Cost)= $25- ($25*.04) = $24 per share

Cost of Equity(upto $1400000) = (Next Dividend/Issue Price)+growth rate

=($1/$24)+.08 = 12.17%

Cost of Equity after 14000000 = ($1.00/ 21.75)+0.08 = 12.60%

Net Proceed per Share= Issue Price-Flotation Cost

3- Cost of Debt-

4- Cost of Preference Share-

Assuming that Dividend tax will same as Income Tax rate (25%)

Cost of Preference Stock =(Dividend+dividend Tax)/ Net Proceed

upto Upto After Debt Level 225000 225000 to300000 300000 Cost before Tax 10% 11.50% 13.54% Tax Rate 25% 25% 25% After Tax Cost of Debt 7.50% 8.63% 9.75%

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