Gaggle Internet, Inc. is evaluating its cost of capital under alternative financ

Question

Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. In consultation with investment bankers, Gaggle expects to be able to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Gaggle is currently selling for $20.00 a share. Gaggle expects to pay a dividend of $1.50 per share next year. Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year. Gaggle' marginal tax rate is 35%.

a) If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Gaggle's cost of capital?

b) If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Gaggle’s cost of capital?

Explanation / Answer

The cost of debt = 8% after tax cost of debt =8%(1-0.35) = 0.65

Cost of preferred = 2.5/25 = 10%

Cost of equity = D1/P0 + g

=1.5/20 + 0.05 = 0.125 or 12.5%

A) cost of capital = 0.45*5.2% + 0.05*10% + 0.5*12.5% = 2.34 +0.5% + 6.25% = 9.09%

B) cost of capital = 0.3*5.2% + 0.05*10% + 0.65*12.5% = 1.56% + 0.5% +8.125 = 10.185%

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