Question

Alcon Inc’s product line has expanded from pharmaceuticals to the surgical arena. Today, Alcon has operations in 75 countries and their products are sold in over 180 countries. Alcon Inc. received a very large order from a few African countries. In order to be able to supply these countries with its products, Alcon will have to expand its facilities. Of the required expansion, Alcon feels it can raise $80 million internally, through retained earnings. The firm's optimum capital structure has been 40% debt, 10% preferred stock and 50% equity. The company will try to maintain this capital structure in financing this expansion plan. Currently Alcon's common stock is traded at a price of $30 per share. Last year's dividend was $2.00 per share. The growth rate is 10%. The company's preferred stock is selling at $60 and has been yielding 5% in the current market. Flotation costs have been estimated at 4% of common stock and 2% of preferred stock. Alcon Inc. has bonds outstanding with coupon (annual) at 8%, but its investment banker has informed the company that interest rates for bonds of equal risk (required rate of return) are currently yielding 6%. Alcon’s tax rate is 30%. Round the answers to two decimal places. PLEASE SHOW YOUR WORK

a) Compute the after-tax cost of debt (K_d,)

b) Compute the cost of preferred stock (K_p,)

c) Compute the cost of retained earnings (K_e, )

d) Compute the cost of equity assuming the company issues new common stock (K_n.)

e) Calculate the initial weighted average cost of capital using K_e.

f) How large a capital budget can the firm support with retained earnings financing?  

Answer 1

As per rules I will answer the first 4 sub parts of this question

a.Cost of debt = Current yield * (1-Tax) = 6%*(1-0.3)

= 4.2%

b.Cost of preferred stock= Dividend/ (Price- Floatation cost)

=5%*60 / (60-2%*60)

= $3/ 58.8

=5.1%

c.Cost of retained earnings= cost of equity without floatation cost

Using CAPM model

P0 = D1/ (Ke- g)

30= 2*110%/ (Ke-0.1)

Ke= 2.2/30 + 0.1

= 17.33%

d: Cost of equity =

Using CAPM model

P0 – F = D1/ (Ke- g)

30-4%*30 = 2*110%/ (Ke-0.1)

Ke= 2.2/28.8 + 0.1

= 17.64%