48 Cost of Capital Exercises: The capital structure for 3C Corporation is provid

Question

48 Cost of Capital Exercises: The capital structure for 3C Corporation is provided below. The company plans to maintain it capital structure in the future. If the firm has a 4% after-tax cost of debt, a 10% cost of preferred stock, and a 16% cost of common stock, what is 3C's weighted cost of capital? Capital structure Bonds Preferred stock S3,000,000 1,000,000 Common stock 6,000,000 $10,000,000 Total IL. Comprehensive Cot of Capital Problem. The Triple Seven Systems, Inc. (TSS), is starting its planning process for next year. Jack Tripper, the firm's CFO, calculates the weighted cost of capital each year to be used as a discount rate in the NPV analysis. You have been asked to help Mr. Tipper to compute the firm's cost of capital. You have collected the following data to do the job: TSS bonds carry a coupon rate of 5% with semi-annual payments, a $1,000 par, a AAA rating, and a maturity of 10 years. The current price of the TSS bonds is $920. b. TSS preferred stock currently pays a 10% dividend rate on a $100 par value and has a market value of $90 per share. TSS common shares paid a dividend of $2 last year. Dividends have grown at a rate of 6% per year and are expected to continue for a foreseeable future. The market price of the stock is $50 and there would be a flotation cost of 5% on a new issue c. d. TSS' capital structure is as follows: 3,000,000 Bonds (3,000 bonds outstanding) Preferred stock (10,000 shares outstanding) Common stock (600,000 shares) 1,000,000 6,000,000 e, The firm's tax rate is 40%. Beta is 1.30, 10-year Treasury bond currently yields 3% (r), and the expected market return (m) is 10%.

Explanation / Answer

1) WACC = wd x kd x (1 - tax) + wps x kps + we x ke

Here, wd - weight of debt = 3/10 = 30%, wps - weight of preferred stock = 1/10 = 10%, we - weight of equity = 6/10 = 60%, kd x (1 - tax) - After-tax cost of debt = 4%, kps - cost of preferred stock = 10%, ke - cost of equity = 16%

=> WACC = 30% x 4% + 10% x 10% + 60% x 16% = 11.80%

2)

a) Before-tax cost of debt can be calculated using I/Y function on a calculator or RATE function in excel

N = 10 x 2 = 20, PMT = 5% x 1000/2 = 25, PV = -920, FV = 1000 => Compute I/Y = 3.04% (semi-annual)

=> Annualized cost of debt = 3.04% x 2 = 6.08%

After-tax cost of debt = Cost of debt x (1 - tax rate) = 6.08% x (1 - 40%) = 3.65%

b) Using DCF, Cost of retained earnings = D0 x (1 + g) / P + g = 2 x (1 + 6%) /50 + 6% = 10.24%

Using CAPM, Cost of equity = Rf + beta x (Rm - Rf) = 3% + 1.3 x (10% - 3%) = 12.10%

c) Cost of preferred debt = Dividend / Price = 10% x 100 / 90 = 11.11%

d) Cost of new equity = D0 x (1 + g) / P x (1 - f) + g = 2 x 1.06 / (50 x (1 - 5%)) + 6% = 10.46%

e) Market Value of equity = No. of shares x Stock Price = 6m x 50 = $300 million

Market Value of preferred stock = No. of preferred shares x Share Price = 0.1m x 90 = $9 million

Market Value of debt = No. of bonds x Bond Price = 3,000 x 920 = $2.76 million

Total Market Value = 300 + 9 + 2.76 = $303.66 million

Using retained earnings, WACC = wd x kd + wps x kps + we x ke

= 2.76 / 303.66 x 3.65% + 0.9 / 303.66 x 11.11% + 300 / 303.66 x 10.24% = 10.18%

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