Question

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? 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

Cost of Debt after tax = 8% * (1-0.35) = 5.2%

(At par Value the Coupon Rate and the YTM are equal. so we have taken Coupon as Cost of Debt)

Cost of Preferred Equity = Dividend / Price

= 2.5 / 25

= 10%

Value of Equity =

20 =

20* Rate of Return - 20* 0.05 = 1.50

20* Rate of Return - 1 = 1.50

Rate of Return = 1.50 + 1 / 20

Rate of Return = 12.50%

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

= 12.50% * 0.50 + 5.2% * 0.45 + 10% * 0.05

= 9.09%

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

= 12.50% * 0.65 + 5.2% *0.30 + 10% * 0.05

= 10.19%