Question

Calculation of individual costs and WACC Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket

Debt The firm can raise debt by selling $1,000-par-value, 9% coupon interest rate, 18-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $20 per bond would have to be given. The firm also must pay flotation costs of $20 per bond.

Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing and selling the preferred stock is expected to be $4 per share. Preferred stock can be sold under these terms

Common stock The firm's common stock is currently selling for $85 per share. The firm expects to pay cash dividends of $7.5 per share next year. The firm's dividends have been growing at an annual rate of 6%,and this growth is expected to continue into the future. To sell new shares of common stock, the firm must underprice the stock by $5 per share, and flotation costs are expected to amount to $6 per share. The firm can sell new common stock under these terms.

Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $140,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the firm's weighted average cost of capital using the capital structure weights shown in the following table,(Round answer to the nearest 0.01%)

THE TABLE :

Long-term_debt 30%

Preferred_stock 15%

Common_stock_equity 55%

Total 100%

a. The after-tax cost of debt using the approximation formula is

(Round to two decimal places.)

The after-tax cost of debt using the bond's yield to maturity (YTM) is

(Round to two decimal places.)

b. The cost of preferred stock is

.

(Round to two decimal places.)

c. The cost of retained earnings is

(Round to two decimal places.)

The cost of new common stock is

(Round to two decimal places.)

d. Using the cost of retained earnings, the firm's WACC is

(Round to two decimal places.)

Using the cost of new common stock, the firm's WACC is

(Round to two decimal places.)

Answer #1

**a]**

Approximation formula

after-tax cost of debt = YTM * (1 - tax rate)

YTM = (C + (F - P) / n) / ((F + P / 2)

where C = annual coupon payment = face value * coupon rate = $1,000 * 9% = $90

F = face value of bond

P = net proceeds of bond = face value - flotation - discount = $1,000 - $20 - $20 = $960

n = years to maturity

YTM = ($90 + ($1,000 - $960) / 18) / (($1,000 + $960 / 2) = 9.41%

after-tax cost of debt = YTM * (1 - tax rate)

after-tax cost of debt = 9.41% * (1 - 40%) = 5.65%

Using the bond's yield to maturity(YTM)

cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 18 (18 years to maturity with 1 annual coupon payment each year)

pmt = 1000 * 9% (annual coupon payment = face value * annual coupon rate. This is a positive figure as it is an inflow to the bondholder)

pv = -960 (Net proceeds per bond. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 9.47%. This is the YTM.

cost of debt = YTM * (1 - tax rate)

**cost of debt** = 9.47% * (1 - 40%) ==>
5.68%

**b]**

cost of preferred stock = (annual dividend / net proceeds per share)

annual dividend = face value * dividend rate = $95 * 8% = $7.60

net proceeds per share = price of share - flotation cost

net proceeds per share = $95 - $4 = $91

cost of preferred stock = $7.60 / $91 = 8.35%

**c]**

cost of retained earnings = (next year dividend / current share price) + growth rate

cost of retained earnings = ($7.5 / $85) + 6% = 14.82%

cost of new common stock = (next year dividend / net proceeds per share) + growth rate.

net proceeds per share = price of share - underpricing - flotation cost = $85 - $5 - $6 = $74

cost of equity = ($7.5 / $74) + 6% = 16.14%

**d]**

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

Using the cost of retained earnings

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

WACC = (30% * 5.68%) + (15% * 8.35%) + (55% * 14.82%)

WACC = 11.11%

Using the cost of new common stock

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

WACC = (30% * 5.68%) + (15% * 8.35%) + (55% * 16.14%)

WACC = 11.83%

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