Question

Badmmans Firearms Company has the following capital structure, which it considers to be optimal: debt = 17%, preferred stock = 12%, and common equity = 71%.

Badman’s tax rate is 35%, and investors expect earnings and dividends to grow at a constant rate of 8% in the future. Badman's expected net income this year is $395,840, and its established dividend payout ratio is 24%. Badmans paid a dividend of $6.75 per share last year (D 0 ), and its stock currently sells for $96 per share. Treasury bonds yield 3%, an average stock has 10% expected rate of return, and Badmans beta is 1.75. These terms apply to new security offerings:
Common: New common stock would have a floatation cost of 16%.

Preferred: New preferred could be sold to the public at $122 per share with a dividend of $7.50. Floatation costs of $11 would be made.

Debt: Debt may be sold at an interest of 9.5%.

Find the following:

A: Component cost of debt

B: Component cost of preferred

C: Component cost of retained earnings (DCF)

D: Component cost of retained earnings (CAPM)

E: Component cost of new equity (DCF)

F: Capital budget before Badmans must sell new equity (the breakpoint)

G: WACC retained earnings

H: WACC new equity

Answer 1

A)	Component cost of debt = 9.5*(1-0.35) =	6.18%
B)	Component cost of preferred = 7.5/(122-11) =	6.76%
C)	Component cost of retained earnings (DCF) = 6.75*1.08/96+0.08 =	15.59%
D)	Component cost of retained earnings (CAPM) = 3+1.75*(10-3) =	15.25%
E)	Component cost of new equity (DCF) = 6.75*1.08/(96*84%)+0.08 =	17.04%
F)	New equity break point = 395840/0.71 =	$      5,57,521
h)	WACC Retained earnings = 6.18*17%+6.76*12%+15.42*71% =	12.81%
	[Cost of retained earnings = (15.59+15.25)/2 = 15.42%]
i)	WACC with new equity = 6.18*17%+6.76*12%+17.04*71% =	13.96%