Abc Inc. has decided that the capital it is raising will consist of 10% preferre

Question

Abc Inc. has decided that the capital it is raising will consist of 10% preferred stock, 20% common stock, 30% retained earnings, and 40% debt. Abc has outstanding 20 year semi-annual, 6% coupon bonds selling for $1,050. The par value of the bonds is $1,000. Abc’s common stock sells for $50 per share. Abc expects that it will pay a $3 dividend next year and that its dividend will grow at 6% a year. If Abc sells new common it must pay a $5 per share flotation fee. Abc’s preferred stock currently sells for $54, and its annual dividend is $4 per share. If Abc were to sell new preferred stock, it would pay $4 per share as flotation cost. Abc’s tax rate is 40%. a. What is Abc’s after tax cost of debt capital? b. What is Abc’s cost of preferred stock capital? c. What is Abc’s cost of common stock? d. What is Abc’s cost of retained earnings? e. What is Abc’s cost of capital?

Explanation / Answer

First of all lets find cost of each component of capital

a) Abc’s after tax cost of debt capita = Kd = Interest rate (1-tax rate)

here interest rate is mentioned to be semi annual , first we have to convert it into annual rate

Annaul rate = (1+6%/2)^2 - 1

=(1+0.3)^2 -1

=1.06093-1

=6.093%

cost of debt = 6.093%(1-40%)

=6.093%(0.6)

=3.656%

b) Abc’s cost of preferred stock capital

Kp = Dividend/(price-flotation cost)

=4/(54-4) *100

=8%

C) cost of equity

Ke= D1/Po +g

=3/(50-5) + 0.06

0.066 + 0.06

=12.67%

d) Cost of retained earning = D1/Po +g

=3/50 +0.06

0.06+0.06

=12%

e) Statement showing WACC

Thus WACC = 8.3964%

Particulars Weights K WACC= Weights*k Equity 20% 0.1267 0.02534 Retail earnings 30% 0.12 0.036 Debt 40% 0.03656 0.014624 Preference shares 10% 0.08 0.008 0.083964

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