Question

The capital structure of company LM is given below:

Sources of capital Book value ($ 000)

Debts 16,000

Preferred stock 4,000

Common stock 10,000

Ret.earn.re) 20,000

Total capital 50,000

The interest rate for debt is 10%, price of preferred stock is $4 per share, price of common stock is $4.8 per share. Company pays out dividend $1 per share to common stock and $1.1 to the preferred stock. The expected growth rate is 6%, corporate -and income tax rates are 20% and 25% respectively. Calculate and comment the weighted average cost of capital of the firm.

Answer 1

Cost of Debt after tax = 10% (1-20%) = 8%

Cost of Equity And Retained Earnings = Dividend after tax / value of Common Stock

= 1 * (1-25%) / 4.8

= 15.625%

Cost of preferred Equity = Dividend after tax / value of Preferred Stock

= 1.1(1-0.25) / 4

= 20.625%

WACC = (Cost of Equity * Weight of Equity with Retained Earnigns) + (Cost of Debt after tax * Weight of Debt) + (Cost of Preferred Stock * Cost of Preferred Stock)

= 15.625% * (10000 + 20000) / 50000 + 8% * 16000 / 50000 + 20.625% * 4000 / 50000

= 13.59%

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