Question

# A firm has determined its optimal capital structure, which is composed of the following sources and...

1. A firm has determined its optimal capital structure, which is composed of the following sources and target market value proportions:
 Source of capital Target Market Proportions Long-term Debt 30% Preferred stock 5% Common stock equity 65%

Debt: The firm 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: The firm 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: The firm'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. Additionally, the firm's marginal tax rate is 40 percent.

Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings.

WACC=16.00%

Workings:

After tax cost of debt = 5.67%

 NPER 20 FV 1000 PMT 90.00 [1000*9%] PV 960.00 [980 -(1000*2%] Rate 9.45% [Rate ( nper, pmt,-pv,fv)] YTM 5.67% [9.45%*(1-40%)]

Cost of preferred stock = 8/ (65-3) =  12.90%

Cost of common stock :

Growth rate : 3.45* ( 1+g) ^5 = 5.07

Growth rate = 8.00%

Cost of capital = [5.07/ (40- 1)] + 8% = 21%

 Source Target Market Proportions Cost (a)*(b) (a) (b) Long-term Debt 30% 5.67% 1.70% Preferred stock 5% 12.90% 0.65% Common stock equity 65% 21.00% 13.65% WACC 16.00%

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