Question

Directions: Answer the following questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link above.

A. Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Bad Boys, Inc. is currently selling for $20.00 a share. Bad Boys, Inc. expects to pay a dividend of $1.50 per share next year. An equity analyst foresees a growth in dividends at a rate of 5% per year. Bad Boys, Inc. marginal tax rate is 35%. If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Bad Boys cost of capital?

B. If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys cost of capital?

Answer 1

As Bad Boy raise new debt at par the debt's yield or cost is going to be equal to the debt's coupon rate of 8 %

Hence, cost of debt = kd = 8 %

Preferred Dividend = $ 2.5 per share and Issue Price = $ 25

Cost of Preferred Equity = kp = 2.5 / 25 = 0.1 or 10 %

Common Stock Price = P0 = $ 20, Expected Dividend = D1 = $ 1.5 per share and Dividend Growth Rate = g = 5 % per annum

Therefore, cost of common equity = ke = (D1/P0) + g = (1.5/20) + 0.05 = 0.125 or 12.5 %

Tax Rate = t = 35 %

(A) Common Equity = E = 50 %, Preferred Equity = P = 5 % and Debt = D = 45 %

Cost of Capital = kd x D x (1-t) + ke x E + kp x P = 8 x (1-0.35) x .45 + 12.5 x 0.5 + 0.1 x 0.05 = 9.09 %

(B) Common Equity = E = 65 %, Preferred Equity = P = 5 % and Debt = D = 30 %

Cost of Capital = kd x D x (1-t) + ke x E + kp x P = 8 x (1-0.35) x 0.3 + 12.5 x 0.65 + 10 x 0.05 = 10.185 %