Question

Answer the following questions in a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both.

Please respond to the following:

1. Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Bad Boys, Inc. is currently selling for $20.00 a share. Bad Boys, Inc. expects to pay a dividend of $1.50 per share next year. An equity analyst foresees a growth in dividends at a rate of 5% per year. The Bad Boys, Inc. marginal tax rate is 35%. If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Bad Boys, Inc.’s cost of capital?
2. If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys, Inc.’s cost of capital?

Answer 1

Since Price and Par Value are same YTM is same coupon rate
Cost of Debt =8%
Cost of Preferred Stock =Dividend/Preferred Stock Share =2.50/25 =10%
Cost of Equity =Dividend Next Year/Price+growth =1.50/20+5% =12.5%

If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Bad Boys, Inc.’s cost of capital =Weight of Equity*Cost of Equity+Weight of Preferred Stock*Cost of Preferred Stock+Weight of Debt*Cost of Debt*(1-Tax Rate) =50%*12.5%+5%*10%+45%*8%*(1-35%) =9.09%

If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys, Inc.’s cost of capital =Weight of Equity*Cost of Equity+Weight of Preferred Stock*Cost of Preferred Stock+Weight of Debt*Cost of Debt*(1-Tax Rate) =65%*12.5%+5%*10%+35%*8%*(1-35%) =10.45%