Question

Wealth Drilling Management is evaluating an opportunity to take on a project in the oil and...

Wealth Drilling Management is evaluating an opportunity to take on a project in the oil and gas industry in Dubai. To properly assess the opportunity, the company must calculate its cost of capital. ut of The following is the existing capital structure based on the book value: Debentures $12,000,000 5,000,000 Preferred Shares Common Shares 10,000,000 Retained Earnings 15,000,000 TOTAL $ 42,000,000 The debentures have a coupon rate of 11% and were issued 20 years ago with 15 years left to maturity. Current market yields on a security of this risk level are 8%. Flotation costs would be 2.5% of the issue price. The preferred shares have a fixed dividend rate of 9%, were issued at $40 per share and currently trade at $45 per share. A new issue would require a flotation cost of 4%. The company has been enjoying a stable growth in the last 5 years with its dividends growing from $0.80 per share to $1.18 per share that was just paid. It is anticipated that the growth rate will continue going forward. There are 5 million common shares currently outstanding and are trading at $15 per share. New shares will be issued at $15 per share also with flotation costs of 8%. Intemally generated funds will have to be supplemented by new external sources for the equity contribution to the new capital project. The tax rate is 30%. The market value of debt is: $15,081,412 $17,491,025 $12,000,000 $8,789,432 The market value of Preferred: $5,625,000 $7,391,825 $5,000,000 $6,526,321 The market value of Common Stocks is: 10 FI Home Prtsen F8 Ens F3 F4 F5 F6 F7 % A & 2 3 4 5 7 8 9 The market value of Common Stocks is: $75,000,000 $46,800,000 $52,000,000 $64,000,000 The After-tax cost of debt is: 5.74% 6.21% 5.6% 4.31% The cost of preferred is: 8.33% 5.34% 8.91% 5.42% The cost of common equity is: 17.93% 16.34% 8.79% 21.25%

Homework Answers

Answer #1

Solution:-

1: $15,081,412

2: $5,625,000

3: $75,000,000

4: 5.6%

5: 8.33%

6:17.93%

Detailed answer:

1: Using financial calculator

Input: FV= 1000, PMT=11%*1000=110

N=15

I/Y=8

Solve for PV as -1256.78

Market value of debt = 12000*1256.78 = $15,081,412.33

2:MV of preferred stock = 5000000*45/40 = 5625000

3: MV of common stock= 5000000*15= 75000000

4: After tax cost of debt = YTM*(1-tax) = 8%*(1-30%) = 5.6%

5: The cost of preferred = Dividend/Price after flotation

= 9%*40/(45*96%)

= 8.33%

6: Growth rate: Using financial calculator

Input:PV= 0.8, FV=1.18,N=5

Solve for I/Y as 8.08%

Cost of equity = D1/Price after flotation +g

= 1.18*108.08%/(15*92%)+8.08%

= 17.33%

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