Question

1. The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent semi-annual coupon, and are currently selling for $874.78.

2. You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00.

3. The company has 5 million shares of common stock outstanding with a currently price of $17.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.65.

4. The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 13 percent. Your stock’s beta is 1.22.

5. Your firm only uses bonds for long-term financing.

6. Your firm’s federal + state marginal tax rate is 40%. (Ignore any carryforward implications)

Depreciation Schedule Modified Accelerated Cost Recovery System (MACRS)
Ownership Year	5-Year Investment Class Depreciation Schedule
1	20%
2	32%
3	19%
4	12%
5	11%
6	6%
Total =

Find the costs of the individual capital components:

 long-term debt (before tax and after tax)

 preferred stock

 average cost of retained earnings (avg. of Capital Asset Pricing Model & Gordon Growth Model/Constant Growth Model)

Answer 1

1) Cost of debt before tax is the Yield to maturity of the bonds.

Using financial calculator, enter

FV=1000 (Face value)

N=15*2=30 (Term of bond)

PMT= 10%*1000/2 = 50 (Coupon)

PV= -874.78 (Price of bond)

Solve for I/Y as 5.90

This is the semiannual yield of the bond

Annual YTM= 5.9%*2= 11.80%

Pre tax cost of debt= 11.80%

After tax cost = Pre tax cost of debt*(1-tax rate)

= 11.80%*(1-40%)

= 7.08%

2) Cost of preferred stock = Annual dividend/ Cost

=9%*1000/900

= 90/900

=10%

3) Cost of retained earnings by CAPM= Rf+ Beta*(Rm-Rf)

= 6%+ 1.22*(13%-6%)

= 14.54%

Cost of retained earnings by Gordon Growth Model= D1/Price + growth rate

= 0.65*110%/17+ 10%

= 14.20588%

Average cost of retained earnings= (14.54%+14.20588%)/2

= 14.37%