4. Haroldson Inc. common stock is selling for $22 per share. The last dividend w

Question

4. Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of the selling price. What is the cost of Haroldson Inc.'s new common stock? 5. Kokapeli, Inc. has a target capital structure of 40% debt and 60% common equity, and has a 4056 marginal tax rate. If the firm's yield to maturity on bonds is 7.5% and investors require a 15% return on the firm's common stock, what is the firm's WACC? 6. Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock. What is the cost of internal common equity if the long-term growth in dividends is projected to be 8 percent indefinitely? 7. APR Company's preferred stock is currently selling for $28.00, and pays a perpetual annual dividend of $2.00 per share. New issue of preferred stock would have S3 per share in flotation costs. The firm's tax rate is 40%. Compute the cost of new preferred stock?

Explanation / Answer

Current price of a share=Present value of future cash flows

Cash flow is the dividend received.

Hence the current price is equal to present value of all future dividends.

When there is constant dividend in perpetuity like in question 7 where there is constant dividend in perpetuity is $2 per year,

If the cost or expected return is Kp,

The present value =2/(1+Kp)+2/((1+Kp))^2)+ 2/((1+Kp))^3)+……..up to infinity

This is equal to 2/Kp

We subtract flotation cost from the price to get (P0-F)=2/Kp

In case dividend is not constant, but growing at a constant rate like in problem problem 4 (constant rate of growth of 6%)

The growing dividends need to be discounted to get the present value.

Dividend of year 1=$1.20*(1+0.06)

Dividend year2=1.20*((1+1.06)^2)

So on up to infinity.

Present Value=22=1.2*(1.06)/(1+Kp)+(1.2*((1.06^2))/((1+Kp)^2)……. Upto infinity

Present value P0=22=1.2/(Kp-0.06)

Flotation cost needs to be subtracted from the present value

WACC or Weighted Average Cost of Capital of a company is what the name implies ; just the weighted average cost. A company has debt and equity.

Suppose weight of debt is w1 and weight of equity =w2

W1+w2=1

WACC=w1*Cost of debt +w2* cost of equity

Cost of debt is the interest paid for the debt minus the tax benefit available for the debt.

Interest expenses are tax deductible. Hence after tax cost of debt is lower than the interest paid

After all expenses (including taxes and interest) what remains is the shareholders wealth.

Hence, for cost of equity , there is no tax benefit. Cost of equity is the required rate of return by the shareholders. This is calculated as shown in solution 4, 6 and 7 for calculation of Kp. Kp is the cost of equity

WACC is calculated by weighted average of the two costs.

This is how the WACC is determined in solution 5

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