Question

Q#1: MidStrata Company is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. John, 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 6.5 percent coupon rate and a convertible bond with a 4.5 percent rate. The firm has been informed by its investment dealer that bonds of equal risk and credit rating are now selling to yield 7.5 percent. The common stock has a price of $74 and an expected dividend (D1) of $2.20 per share. The firm’s historical growth rate of earnings and dividends per share has been 9.2 percent, but security analysts on Bay Street expect this growth to slow to 7 percent in the future years. The preferred stock is selling at $70 per share and carries a dividend of $8.50 per share. The corporate tax rate is 30 percent. The flotation cost is 3.3 percent of the selling price for preferred stock. The optimum capital structure for the firm seems to be 40 percent debt, 10 percent preferred stock, and 50 percent common equity in the form of retained earnings. a) Compute the cost of capital for the individual components in the capital structure. b) Calculate the weighted average cost of capital.

Answer 1