Question

# Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to...

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?

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%

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