Question

METRO MACHINE HAS ASKED ITS FINANCIAL MANAGER TO MEASURE THE COST OF EACH SPECIFIC TYPE OF CAPITAL AS WELL AS THE WEIGHTED AVERAGE COST OF CAPITAL. THE WEIGHTED AVERAGE COST IS TO BE MEASURED BY USING THE FOLLOWING WEIGHTS: 45% DEBT     10% PREFERRED STOCK        AND 45% COMMON EQUITY. ASSUME 21% TAX RATE.

DEBT: THE FIRM CAN BORROW AT 8.25% PRETAX ON AN ALL-IN BASIS

PREFERRED STOCK: 5% (ANNUAL DIVIDEND) PREFERRED STOCK HAVING A PAR VALUE OF $100 CAN BE SOLD FOR $43 PER SHARE. AN ADDITIONAL FEE OF $3 PER SHARE MUST BE PAID AS FLOTATION COST.

COMMON STOCK: THE FIRMS COMMON STOCK IS CURRENTLY SELLING FOR $35 PER SHARE. NEXT YEARS DIVIDEND IS EXPECTED TO BE $3 AND THE DIVIDEND GROWTH RATE IS 6%. IF THE FIRMS SELLS NEW STOCK, IT MUST BE UNDERPRICED BY $2 PER SHARE AND THE FIRM MUST PAY $1 PER SHARE IN FLOATION COST.

A: FIND THE SPECIFIC COST OF EACH OF THE 4 SOURCES OF FINANCING.

B: IF THE FIRM CAN FINANCE ITS BUDGET WITHOUT ISSUING NEW COMMON STOCK, WHAT IS ITS WEIGHTED AVERAGE COST OF CAPITAL?

                           THANKS IN ADVANCE! Show work, thanks again!

Answer 1

Solution-

A.

Cost of debt = 8.25%*(1-0.21)= 6.5175%

Cost of preferred stock =Dividend / (Price - Floatation cost)

Cost of preferred stock = 100*5%/ ( 43-3)= 12.5%

Cost of common stock = Next dividend ( D1) / Price ( P0) + growth (g)

Cost of common stock ( without selling new common stock ) = 3/35 + 0.06= 0.1457 or 14.57%

Cost of common stock ( selling new common stock) = 3/(35-2-1)+0.06= 15.375% or 15.38%

B. Weighted average cost of capital ( without issuing new common stock ) = 6.5175%*0.45 + 12.5%*0.10 + 14.57%*0.45= 10.74%