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). To find the kD, we need to put the following values in the financial calculator:

INPUT	10		-[925*(1-1%)] = -915.75	5%*1,000=50	1,000
TVM	N	I/Y	PV	PMT	FV
OUTPUT		6.15

So, After-Tax kD = 6.15% x (1 - 0.40) = 3.69%

b). KE = [D1/{P0 x (1 - fc)}] + g

= [($3 x 1.06) / ($30 - $2)] + 0.06 = 0.1136 + 0.06 = 0.1736, or 17.36%

c). kRE = [D1/P0] + g

= [($3 x 1.06) / $30] + 0.06 = 0.106 + 0.06 = 0.166, or 16.60%

d). WACC = [wD x After-Tax kD] + [wE x kE] + [wRE x kRE]

= [0.20 x 3.69%] + [0.60 x 17.36%] + [0.20 x 16.60%]

= 0.74% + 10.41% + 3.32% = 14.47%