Individual or component costs of capital Your firm is consid

(Individual or component costs of capital) Your firm is considering a new investment proposal and would like to calculate its weighted average cost of capital. To help in this, compute the cost of capital for the firm for the following:

A bond that has a $1,000 par value (face value) and a contract or coupon interest rate of 10.9 percent that is paid semiannually: the bond is currently setting for a price of $1,129 and will mature in 10 years. The firm\'s tax rate is 34 percent. If the firm\'s bonds are not frequently traded, how would you go about determining a cost of debt for this company?

A new common stock issue that paid a $1.74 dividend last year. The par value of the stock is $16, and the firm\'s dividends per share have grown at a rate of 9.7 percent per year. This growth rate is expected to continue into the foreseeable future. The price of this stock is now $27.88.

A preferred stock paying an 8.3 percent dividend on a $120 par value. The preferred shares are currently setting for $153.18.

A bond setting to yield 12.9 percent for the purchaser of the bond: the borrowing firm faces a tax rate of 34 percent.

Solution

Answer:

A

After tax cost of debt

The cost of the debt

Calculate the pretax cost of debt YTM

YTM= C+[FV-BV]/n/ [FV+BV]/2

Semiannual

C= 0.109/2*1000= 54.5

n=10*2

54.5+[1000-1129]/20]/1000+1129]/2

= 3.87%*2=7.74%

After tax cost of 7.74%*[1-0.34]=

5.12%

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B

Ke (cost of equity)

= [Do(1+g)/P0] + g

=1.74[1.097]/27.88+ 0.097

=16.55%

Ke (cost of equity) =16.55%

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C

Cost of prfferred stock

= annual dividend / Price

=[0.083*$120]/ $153.18

= 120 x 8.30%/153.18

= 6.50%

Cost of preferred stock=6.5%

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D

Cost of debt

After tax cost of debt

=  12.9 percent*[1-0.34]

= 12.90%(1-0.34)

= 8.51%

Cost of debt =8.51%