Brook’s Window Shields Inc. is trying to calculate its cost of
capital for use in a capital budgeting decision. Mr. Glass, the
vice-president of finance, has given you the following information
and has asked you to compute the weighted average cost of
capital.
The company currently has outstanding a bond with a 8.5 percent
coupon rate and another bond with a 5.4 percent coupon rate. The
firm has been informed by its investment banker that bonds of equal
risk and credit rating are now selling to yield 9.5
percent.
The common stock has a price of $78 and an expected dividend
(D1) of $4.20 per share. The firm's historical
growth rate of earnings and dividends per share has been 11.2
percent, but security analysts on Wall Street expect this growth to
slow to 9 percent in future years.
The preferred stock is selling at $74 per share and carries a dividend of $10.50 per share. The corporate tax rate is 40 percent. The flotation cost is 3.5 percent of the selling price for preferred stock. The optimal capital structure is 15 percent debt, 5 percent preferred stock, and 80 percent common equity in the form of retained earnings.
a. Compute the cost of capital for the
individual components in the capital structure. (Do not
round intermediate calculations. Input your answers as a percent
rounded to 2 decimal places.)
debt____%
preffred stock______
common equity________
b. Calculate the weighted cost of each source
of capital and the weighted average cost of capital. (Do
not round intermediate calculations. Input your answers as a
percent rounded to 2 decimal places.)
Debt_______%
preffred stock______
common equity________
weighted average of cost of capital_____________
a. Cost of equity |
As per DDM |
Price= Dividend in 1 year/(cost of equity - growth rate) |
78 = 4.2/ (Cost of equity - 0.09) |
Cost of equity% = 14.38 |
After tax cost of debt = cost of debt*(1-tax rate) |
After tax cost of debt = 9.5*(1-0.4) |
= 5.7 |
cost of preferred equity |
cost of preferred equity = Preferred dividend/price*(1-flotation %)*100 |
cost of preferred equity = 10.5/(-185*(1-3.5))*100 |
=-5.68 |
b. Weighted cost of debt = Weight of debt*cost of debt=0.15*9.5=1.43% |
Weighted cost of Equity = Weight of equity*cost of equity=0.8*14.38=11.5% |
Weighted cost of Preferred Equity = Weight of Preferred equity*cost of Preferred equity=0.05*-5.68=-0.28% |
WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE) |
WACC=5.7*0.15+14.38*0.8+-5.68*0.05 |
WACC =12.08% |
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