Question

Your company issues bonds at a price of $925 and a flotation cost of 1%. The bond has an annual coupon rate of 5% and a maturity of 10 years. The corporate tax rate is 40%.Common stock sells at $30 per share and new issues would have a flotation cost of $2. The last dividend paid was $3 per share and the growth rate of dividends is 6%. Your firm’s capital structure is 20% debt, 20% retained earnings, and 60% common stock.

a)Compute the after-tax cost of debt

b)Compute the cost of common stock

c)Compute the cost of retained earnings

d)Compute the Weighted Average Cost of Capital

Answer 1

a)

Flotation cost of debt = 0.01 * 925 = 9.25

Price after flotation cost = 925 - 9.25 = 915.75

Coupon = 0.05 * 1000 = 50

YTM = 6.153%

Keys to use in a financial calculator: FV 1000, PV -915.75, PMT 50, N 10, CPT I/Y

After tax cost of debt = 0.06153 (1 - 0.4)

After tax cost of debt = 0.0369 or 3.69%

b)

Price after flotation cost = 30 - 2 = 28

cost of common stock = (D1 / share price) + growth rate

cost of common stock = [(3 * 1.06) / 28] + 0.06

cost of common stock = 0.11357 + 0.06

cost of common stock = 0.1736 or 17.36%

c)

cost of retained earnings = [(3 * 1.06) / 30] + 0.06

cost of retained earnings = 0.106 + 0.06

cost of retained earnings = 0.166 or 16.60%

d)

WACC = 0.2*0.0369 + 0.2*0.166 + 0.6*0.1736

WACC = 0.00738 + 0.0332 + 0.10416

WACC = 0.1447 or 14.47%