Question

Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $38.00 per share. The firm's dividend for next year is expected to be $4.10 with an annual growth rate of 7.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external equity?

	18.57%
	17.79%
	18.54%
	20.58%
	19.69%

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 7.0%. Its cost of preferred stock is 11.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $295 million of debt, $45 million of preferred stock, and $160 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for the next period. Its managers have determined that the firm should have $55 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $122 million?

	9.18%
	9.98%
	8.38%
	11.84%
	10.24%

Answer 1

Stock Price – Flotation cost = Expected Dividend/(cost of new equity – growth rate)

38 – 15%*38 = 4.10/(Cost of External Equity – 7%)

Cost of external equity = 19.69%

Marginal cost of capital is the cost of capital for one additional dollar raised

Capital Budget = $122 million

To be financed through Equity = 122 million*160/500 = 39.04 million

Available from retained earnings = $55 million

Hence, external equity will not be required

WACC = After tax Cost of debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 7%*(1-45%)*295/500 + 11%*45/500 + 16%*160/500

=8.3815%

i.e. 8.38%