ncome tax rate Capital Gais Tax Rate Assumed long-term sustainable growth rate 4

Question

ncome tax rate Capital Gais Tax Rate Assumed long-term sustainable growth rate 40% 15% 5% WACC facts: Barking Dog Corp Cost of Capital Given: Optimal Capital Structure 20% Debt 10% Preferred Equity 70% Common Equity Net income for the coming year: $4,000,000 Use Retained Earnings for common equity until all but $1.5 M are exhausted Dividends policy is to distribute 60% of NI as dividends. Currently 0 retained earnings Borrowing Limits and Interest Rates Amount Borrowed Interest Rate 0 to $1,500,000 6% 9% over $1,5000,000 Use the average of CAPM and Dividends growth model for rRE $66 Common Stock price Dy: Preferred Stock price Dpg: S30 $2 $6 for the oming year 5% for this year Float %; Tax rate: For CAPM: 10% of the market price 40% 8.5% 3.5% 1.05 RF Component costs of capital: per AT k BT k(1-T) up to $1,500,000 borrowed per AT k BT k(1-T) if over $1,500,000 borrowed After-tax cost of debt, AT rd (1) After-tax cost of debt, AT rd (2) Cost of Preferred Stock, rp Using DCF Cost of existing equity (RE), E Using CAPM Cost of existing equity (RE), RE Composite (average) Cost of new equity, rn per the dividend growth model per CAPM per the dividend growth model

Explanation / Answer

1. After Tax cost of debt (1) = Before tax cost of debt * (1 - Tax rate)

After Tax cost of debt (1) = 0.06 * (1 - 0.40)

After Tax cost of debt (1) = 0.06 * (1 - 0.40) = 0.06 - 00.24 = 0.036 = 3.6%

2. After Tax cost of debt (2) = 0.09 * (1 - 0.40)

After Tax cost of debt (2) = 0.09 * (1 - 0.40) = 0.06 - 00.24 = 0.054 = 5.4%

3. Cost of Preferred Stock = Dividend / Preferred Stock price = 2 / 30 =0.667 = 6.67%

4. Cost of Equity = Ke = Expected Dividend / Price of share + growth rate

    Ke = 6 / 66 + 0.05 = .0.1409 = 14.09%

5. Using CAPM, Ke = Rrf + Beta* (RM - Rrf )

    Ke = 3.5% + 1.05 * ( 8.5% - 3.5%)

   Ke = 0.035 + 1.05 * 0..05 = 0.035 + 0.0525 = 0.0875 = 8.75%

6. Composite = (8.75% + 14.09%) / 2 = 11.42%

7. Cost of New Equity = Expected Dividend / (Net Proceeds) + growth rate

Net Proceeds = Market Price per share - Floatation cost

Net Proceeds = 66 - 6.6 = 59.4

Ke = 6 / 59.4 +0.05   = 0.1510 = 15.10%

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