Question

X Ltd’s financing policy has established that the optimal capital structure is approximately 60% ordinary equity; 10% preferred equity and 30% debt. X marginal corporate tax rate is 40%. X needs to raise shs 600 million to finance a new project and has collected the following information: The current market price of common stock is shs 500 per share and the firm just issue shs 50 dividend per share. Dividends are expected to grow at a rate of 10% per year indefinetly. In raising ordinary equity, the firm estimates that 60% will be generated internally through retained earnings and 40% through newly issued ordinary equity. Flotation costs on newly issued common stock will be 5% of issue price. Newly issued preferred equity would have a par value of shs 500 per share, a dividend of shs 60 per share, and flotation costs of shs 17.50 per share. X believes that it is most likely that new preferred equity would be issued and sold at par. If the new debt were issued it would have coupon rate of 9%, and maturity 10 years. For a face value of shs 10,000 the issue costs of debt is estimated shs 300. It is expected that since investor’s opportunity cost is also 9% that new debt could be sold at face value. Using the following information, estimate the following:

The cost of current ordinary equity, the cost of new ordinary equity and the overall cost ordinary equity component to be used in financing new project?.

The cost of incremental preferred stock?.

The cost of incremental debt?.

The WACC?

Answer 1

	Amount	Weights	Cost
Ret. Earnings	216	36%	21.00%
New Equity	144	24%	21.58%
Pref. Stock	60	10%	12.44%
Debt	180	30%	9.48%
Total	600	100%	15.69%

Cost of retained earnings, ke1 = D0 x (1 +g) / P + g = 50 x (1 + 10%) / 500 + 10% = 21.00%

Cost of new equity, ke2 = D0 x (1 + g) / (P x (1 - f)) + g = 50 x (1 + 10%) / (500 x (1 - 5%)) + 10% = 21.58%

Cost of new pref. stock, kps = D / (P - F) = 60 / (500 - 17.5) = 12.44%

Cost of debt can be calculated using RATE function in excel or I/Y function on a calculator

N = 10, PMT = 9% x 10000 = 900, PV = -10,000 + 300 = -9,700, FV = 10,000 => Compute I/Y = 9.48% = kd

WACC = we1 x ke1 + we2 x ke2 + wps x kps + wd x kd x (1 - tax)

= 36% x 21% + 24% x 21.58% + 10% x 12.44% + 30% x 9.48% x (1 - 40%)

= 15.69%

answered by: anonymous