Question

Q2. Calculation of individual costs and WACC Golden Palace is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 21% tax bracket. Debt The firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond. Common stock The firm's common stock is currently selling for $35 per share. The firm expects to pay cash dividends of $3.25 per share next year. The firm's dividends have been growing at an annual rate of 5%, and this growth is expected to continue into the future. Required: 1. Calculate the after-tax cost of debt. 2. Calculate the cost of common stock. 3. Calculate the firm's weighted average cost of capital using the capital structure weights 60% debt and 40% equity (Round answer to the nearest 0.1%.)

Answer 1

1

Cost of debt

K = N

Bond Price -flotation cost =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =20

970-30 =∑ [(8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 8.6405273415

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.6405273415*(1-0.21)

= 6.83

2

Cost of equity

As per DDM

Price= Dividend in 1 year/(cost of equity - growth rate)

35 = 3.25/ (Cost of equity - 0.05)

Cost of equity% = 14.29

3

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6.83*0.6+14.29*0.4

WACC =9.81%