Question

Practice Questions - Chapter 9 1. McCall Corporation has a capital structure consisting of 55 percent common equity, 30 percent debt, and 15 percent preferred stock. Any debt issues would have a pre-tax cost of 9.5%. Preferred stock can be issued for a cost of 11.5%. Common equity can be issued, but flotation costs of $4.25 per share of common stock would be paid. McCall common stock is currently selling in the market at $65 per share McCall recently paid a dividend of $4 per share and company earnings and dividends are expected to grow at an annual rate of 8% indefinitely. McCall has a tax rate of 21% and the firm wants to keep its current capital structure. If the firm needs to raise additional equity, what will be the firm's cost of capital? E: (.55) a) 11.76% b) 12.04% c) 12.29% d) 11.99% e) 12.89% annonim estan to non D = (-3) 1.095) p= 1.15) (115) 2. A firm has $5 million in retained earnings. The market price of the firm's common stock is $55. The firm recently paid a dividend of $3.70. Earnings and dividends are expected to increase at an annual rate of 9 percent. When new common stock is issued, flotation costs amount to 4 percent of market price. What is the firm's cost of external equity financing? a) 7.6% b) 16.0% d) 16.3% e) 15.7% 3.70 (1.06) 9.55 .04) .09

Answer 1

Answer is Option C

As Per Dividend Capitalization Model -

Cost of Equity (Re) = [D1/P0(1-F)] + g

Where,

D1 = Dividend of Next year i.e D0*(1+g)

P0 = Market Price of Equity Share

F = Ratio of Flotation Cost to Issue Price = 4.25/65 = 0.065385

g = Growth Rate

Therefore,

Re = [ 4*(1+8%) / 65 * (1 - 0.065385) ] + 8%  = 15.11%

Now, Cost of Debt = 9.5 (1- 21%) = 7.505 %

Cost of Preferred Equity = 11.5%

Therefore Cost of Capital for New Issue in the Same Structure -

COC = 55% * 15.11 + 30% * 7.505 + 15% * 11.5% = 12.28761 % (Option C)

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