Question

DMH Enterprises recently hired you to estimate their cost of capital. The firm’s capital structure consists 40% debt, 10% preferred stock and 50% common stock. The firm has outstanding bonds with 15 years left to maturity, par value of $1,000 and an annual coupon of 6%. The bonds currently trade for $695.76. The firm's preferred stock is currently selling for $63.64 and pays a dividend of $7. The firm does not plan on issuing new shares of common equity. It will retain earnings instead. Management has no preferred method for calculating the cost of retained earnings but they provide you with the following information: The company has a beta of 0.8. The risk-free rate is 3% and the market risk premium is 12%. Also, the company’s common stock is risky enough that it commands a premium of 3% over the company’s debt. If the firm faces a flat state-plus-federal tax rate of 25%, what is DMH Enterprises’ cost of capital?

Answer 1

Cost of capital of firm is weighted average cost of capital of each class of its security

Cost of debt

Yield to maturity is before tax cost of capital

= Face value is 1000

Coupon rate is 6%

Redemption value is 1000

Yield to maturity formula is

Coupon+(m.v-n.p)/n/(mv+np)/2

Where coupon is 60 m.v is 695.76 n.p is 1000

(60+(695.76-1000)/15)/(1000+695.76)/2 = 11.7%

Tax rate is 25%

After tax cost of debt is 11.7(1-0.25) = 8.775

Cost of preferred stock

Dividend on preferred stock is 7

Market value is 63.64

Cost of preferred stock is 7/63.64% = 10.99%

Cost of equity

According to capm approach required return is risk free rate plus beta times market risk premium

= 3+0.8(12)= 12.6%

Weight of debt is 40%

Preferred stock is 10%

Equity is 50%

Weighted average cost of capital is

(40(8.775)+10(10.99)+50(12.6))/100 = 10.909%