Question

Cost of capital   

Edna Recording​ Studios, Inc., reported earnings available to common stock of $4,000,000 last year. From those​ earnings, the company paid a dividend of $1.15 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 35​% debt, 15​% preferred​ stock, and 50​% common stock. It is taxed at a rate of 27​%.

a.  If the market price of the common stock is $40 and dividends are expected to grow at a rate of 8​% per year for the foreseeable​ future, what is the​ company's cost of retained earnings financing​?

b.  If underpricing and flotation costs on new shares of common stock amount to ​$8 per​ share, what is the​ company's cost of new common stock financing​?

c.  The company can issue $2.39 dividend preferred stock for a market price of ​$35 per share. Flotation costs would amount to $4 per share. What is the cost of preferred stock financing​?

d.  The company can issue ​$1,000​-par-value, 11​% ​coupon, 10​-year bonds that can be sold for $1,270 each. Flotation costs would amount to ​$40 per bond. Use the estimation formula to figure the approximate​ after-tax cost of debt​ financing?

e.  What is the WACC​?

If the market price of the common stock is ​$40 and dividends are expected to grow at a rate of 8​% per year for the foreseeable​ future, the ​company's cost of retained earnings financing is ____​%. ​(Round to two decimal​ places.)

Answer 1

a)	Cost of retained earnings (using the constant dividend growth model) = 1.15*1.08/40+0.08 =	11.11%
b)	Cost of new common stock = 1.15*1.08/(40-8)+0.08 =	11.88%
c)	Cost of preferred stock = 2.39/(35-4) =	7.71%
d)	Before tax cost of debt = ((110+(1230-1000)/10))/((1230+1000)/2)) =	11.93%
	After tax cost of debt = 11.93%*(1-27%) =	8.71%
e)	WACC (with retained earnings) = 11.11%*50%+7.71%*15%+8.71%*35% =	9.76%
	WACC (with new common stock) = 11.88%*50%+7.71%*15%+8.71%*35% =	10.15%