Question

Sound Systems (SS) has 200 shares of common stock outstanding at a market price of $37 a share. SS recently paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 4 percent. SS also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a 6 percent coupon and a 6.7 percent yield to maturity. If the tax rate is 21 percent. What is the pre-tax cost of equity? What is the pre-tax cost of debt? What is the firm's weighted average cost of capital?

Answer 1

1)

Pre-tax cost of equity = (D1 / share price) + growth rate

Pre-tax cost of equity = [(1.2 * 1.04) / 37] + 0.04

Pre-tax cost of equity = 0.03373 + 0.04

Pre-tax cost of equity = 0.0737 or 7.37%

2)

Pre tax cost of debt = 6.7%

3)

Market value of common stock = 200 * 37 = 7,400

market value of debt = 5 * (99% of 1000) = 4,950

Total market value = $7,400 + $4,950 = 12,350

Firms weight average cost of capital = Weight of debt*after tax cost if debt + weight of equity*cost of equity

Firms weight average cost of capital = (4,950 / 12,350)*0.067*(1 - 0.21) + (7,400 / 12,350)*0.0737

Firms weight average cost of capital = 0.02121+ 0.04416

Firms weight average cost of capital = 0.0654 or 6.54%