Question

QUESTION 4 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Target Market Proportions 20% Source of Capital Long-term debt Preferred stock Common stock equity 10 70 Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings. [Total: 10 marks]

Answer 1

		Target Capital Structure
	Wd	Long Term debt	0.20
	Wp	Preferred Stock	0.10
	We	Common stock equity	0.70
		Cost of Debt:
		Sales Price	$960
		Discount	$40
		Flotation Cost=2%*1000	$20
	Pv	Net amount received on sale=960-40-20	$900
	Nper	Number of years	12
	Pmt	Annual Coupon Payment =1000*7%	$70.00
	Fv	Payment at maturity=Face value	$1,000
	RATE	Before Tax Cost of Bonds	8.35%	(Using RATE function of excel with Nper=12, Pmt=70, Pv=-900,Fv=1000)
	Cd	After tax cost of Bonds =8.35*(1-tax rate)	5.01%	(8.35*(1-0.4)
		Cost of Preferred Stock:
		Selling price per share:	$75
		Cost of issuing	$3
		Amount received per share	$72
		Annual Dividend payment=	$10
	Cp	Cost of Preferred Stock=10/72=	13.89%
		Required Return on Common Equity=Ce
		AS per DCF
		Next Years Dividend =D1=	$1.74
		g=dividend growth rate=g
		(1+g)^5=1.74/1.50=	1.16
		1+g=1.16^(1/5)	1.03
		g=dividend growth rate=1.03-1=	0.03	3%
		Current market Price =$18
		P0=Selling Price of share=18-1=	$17
		Cost of Equity =(D1/P0)+g=(1.74/17)+0.03	13.25%
	Ce	Cost of Equity	13.25%
		Weighted Average Cost of Capital (WACC)=Wd*Cd+Wp*Cp+We*Ce
		Weighted Average Cost of Capital (WACC)=0.2*5.01+0.1*13.89+0.7*13.25
		WACC=	11.67%
										116 - fic =RATE(113,114,-112,115) G E F H Wd Wp We Target Capital Structure Long Term debt Preferred Stock Common stock equity 0.20 0.10 0.70 Pv Cost of Debt: Sales Price Discount Flotation Cost=2%*1000 Net amount received on sale=960-40-20 Number of years Annual Coupon Payment =1000*7% Payment at maturity=Face value Before Tax Cost of Bonds $960 $40 $20 $900 12 $70.00 $1,000 8.35%! Nper Pmt FV RATE (Using RATE fund