(10 points) An investment amount of $10M has to be raised through equity financi
ID: 2805922 • Letter: #
Question
(10 points) An investment amount of $10M has to be raised through equity financing and debt financing. The required debt ratio is 0.45 and the company tax rate is 35%. a) The current market price of the company's common stock is $50 and the current dividend is $5 2. and the dividend is expected to grow at 5% annual rte. The floating cost of issuing a common stock is 10%. Preferred stocks of S100 par value with 10% fixed annual dividend can also be issued at 8% floating cost. If the required proportion of funds from retained earnings to common stocks to preferred stocks are 0.4:0.15:0.45 respectively, what is the cost of equity? b) Bank loans at 12% annual interest. Also, the company issues 20-year bonds that pay the equivalent of 9% yield to maturity. If the required ratio of funds raised through these two methods ofdebt financing is 0.7:0.3 what is the cost of debt? c) From (a) and (b), what is the cost of capital (WACC?Explanation / Answer
a) Cost of retained earnings [re) = D1/P0 + g where D1=next expected dividend, P0=Current price and g=growth rate. re = (5*1.05)/50+0.05 15.50% Cost of new equity [rs] = D1/[P0*(1-f)] +g where f=% floatation cost rs = (5*1.05)/(50*0.9)+0.05 = 16.67% Cost of preferred stock = 10/92 = 10.87% Cost of equity = weighted average cost of the above components of equity, the weights being 0.4:0.15:0.45 of retained earnings/new common equity/preferred stock = 15.50*0.4+16.67*0.15+10.87*0.45 = 13.59% Answer b) Cost of debt is the weighted average of the after tax cost of different debt components After tax cost of bank loan = 0.12*0.65 = 7.80% After tax cost of bonds = 0.09*0.65 = 5.85% Cost of debt = 0.078*0.7+0.0585*0.3 = 7.22% Answer c) WACC = Cost debt * weight of debt+cost of equity*weight of equity = 0.0722*0.45+0.1359*0.55 = 10.72% Answer
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