Question

Southern Corporation has a capital structure of 40% debt and 60% common equity. This capital structure is expected not to change. The firm's tax rate is 34%. The firm can issue the following securities to finance capital investments:

Debt: Capital can be raised through bank loans at a pretax cost of 8.5%. Also, bonds can be issued at a pretax cost of 10%.

Common Stock: Retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $59. Flotation costs will be $3 per share. The recent common stock dividend was $3.15. Dividends are expected to grow at 7% in the future.

What is the cost of capital if the firm uses bank loans and retained earnings?

Answer 1

Debt:

Weight of Debt = 40%
Pretax Cost of Debt = 8.50%

After-tax Cost of Debt = Pretax Cost of Debt * (1 - tax)
After-tax Cost of Debt = 8.50% * (1 - 0.34)
After-tax Cost of Debt = 5.61%

Equity:

Weight of Equity = 60%

Recent Dividend = $3.15
Growth Rate = 7%
Current Price = $59.00

Expected Dividend = Recent Dividend * (1 + Growth Rate)
Expected Dividend = $3.15 * 1.07
Expected Dividend = $3.3705

Cost of Retained Earnings = Expected Dividend / Current Price + Growth Rate
Cost of Retained Earnings = $3.3705 / $59 + 0.07
Cost of Retained Earnings = 0.1271 or 12.71%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Retained Earnings
WACC = 0.40 * 5.61% + 0.60 * 12.71%
WACC = 9.87%