Lang Enterprises is interested in measuring its overall cost of capital. Current
ID: 2780528 • Letter: L
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.
DEBT: The firm can raise debt by selling $1,000 par value, 8% coupon interest rate, 20 year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond.
PREFERRED STOCK: The firm can sell 8% preferred stok at its $95 per share par value. the cost of issuing and selling the preferred stock is expected to be $5 per share. Preferred stock can be sold under these terms.
COMMON STOCK: The firm's common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The firm's dividends have been growing at an annual rate of 6% and this growth is expected to continue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell new common stock under these terms.
RETAINED EARNINGS: When measuring this cost, the firm does not have concern itself with the tax racket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year'; once these retained earnings are exhausted, 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 cosst of common stock,.
d Calculate the firm's weighted average cost of capital using he capital structure weights shown in the following table. (Round answer to the nearest 0.1%)
Source of Capital Weight
Long-Term Debt 30%
Preferred Stock 20
Common Stock Equity 50
Total 100%
Explanation / Answer
Cost of debt can be calculated using I/Y function on a calculator
N = 20, PMT = 8% x 1000 = 80, PV = - (1000 - 30 - 30) = -940, FV = 1000
Compute I/Y = 8.64%
After-tax cost of debt, kd = 8.64% x (1 - 40%) = 5.18%
Cost of preferred stock, kps = Dividend / Price = 8% x 95 / (95 - 90) = 8.44%
Using dividend growth model,
Cost of new equity, ke = D1 / (D - f) + g = 7 / (90 - 7 - 5) + 6% = 14.97%
WACC = wd x kd + wps x kps + we x ke
= 30% x 5.18% + 20% x 8.44% + 50% x 14.97%
= 10.73%
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