Question

COST OF CAPITAL

With several new investment opportunities, it is necessary for you to first know AB Designs’ weighted average cost of capital (WACC). This critical information will inform your analysis on what investments are profitable along with identifying the best financing option.  

Business Problem:

AB Designs capital structure is composed of the following sources and target weights that represent the proportion of use for each. AB Designs tax rate is 40%.

Source of Capital	Weight
Long-term loan	10%
Long-term bonds	30%
Preferred Stock	5%
Common Stock Equity	55%

Debt:

AB Designs has a long-term loan with North Shore bank, financed at a 10% interest rate.

AB Designs can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20.

Preferred Stock:

AB Designs has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock:

AB Design’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation costs.    

Identify AB Designs’ WACC.  

Answer 1

the wacc would be :

1.weight of long term loan (interest rate of long term loan)(tax rate)0.1*0.1*0.6=0.006

weight of bonds*interest rate of bonds *tax rate

interest rate on bonds calcualtion:

fv=1000

pv=(958) =(980-2-20)

n=20

pmt=90

i/y=9.47

so the long term bonds weight* rate of interest *tax rate

(0.3)(0.0947)(0.6)=0.017

cost of prefered stock : 8/62= 0.129

weight of preffered stock is

0.05*0.129=0.0065

cost of equity Re= d1/po +g

calculate the arte of dividends growth:

3,45(1+g)^4=5.07

g=10%

now putting in the g in the formula we get

5.07/38+0.10=0.2439

weight is 0.55*0.2268=0.1342

so wacc will be 16.37