Question

Bay Beach Industries wants to maintain their capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments:

Bonds: Mortgage bonds can be issued at a pre-tax cost of 9 percent. Debentures can be issued at a pre-tax cost of 10.5 percent.

Common Equity: Some retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $46. Flotation costs will be $3 per share. The recent common stock dividend was $3.60. Dividends are expected to grow at 6% in the future.

What is the cost of capital using mortgage bonds and internal equity?

Answer 1

The cost of capital for Bay Beach is :

USING MORTGAGE BONDS :

Pretax cost of 9%

so, after tax cost of mortgage bonds( debt ) is 9% * ( 1-0.34)

=5.94%

Using internal equity we get,

we can calculate the require rate of return using the Gordon growth model,

dividends paid next year/ current stock price + growth rate

Re = D1/ ( Po ) + G

=(3.6 * 1.06) /46 + 0.06

= 14.3%

So, the WACC is :

weight of debt * after tax cost of debt + weight of equity * cost of equity

=0.4* 5.94% + 0.6* 14.3%

=0.0238 + 0.0858

=10.96%