P916 similar to Question Help Cost of capitalEdna Recording

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Cost of capitalEdna Recording Studios, Inc., reported earnings available to common stock of $4,800,000 last year. From those earnings, the company paid a dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 45% debt, 25% preferred stock, and 30% common stock. It is taxed at a rate of 35%.

a.If the market price of the common stock is $49 and dividends are expected to grow at a rate of 5% per year for the foreseeable future, what is the company\'s cost of retained earnings financing?

b.If underpricing and flotation costs on new shares of common stock amount to $6 per share, what is the company\'s cost of new common stock financing?

c.The company can issue $1.79 dividend preferred stock for a market price of $30 per share. Flotation costs would amount to $4 per share. What is the cost of preferred stock financing?

d.The company can issue $1,000-par-value, 12% coupon, 6-year bonds that can be sold for $1,270 each. Flotation costs would amount to $40 per bond. Use the estimation formula to figure the approximate after-tax cost of debt financing?

e.What is the WACC?

Solution

Answer a.

Dividend paid, D0 = $1.26
growth rate, g = 5%
Current Price, P0 = $49

D1 = $1.26 * 1.05
D1 = $1.323

Cost of Retained Earnings = D1 / P0 + g
Cost of Retained Earnings = $1.323 / $49 + 0.05
Cost of Retained Earnings = 0.077 = 7.70%

Answer b.

Dividend paid, D0 = $1.26
growth rate, g = 5%
Current Price, P0 = $49
Flotation Cost, F = $6

D1 = $1.26 * 1.05
D1 = $1.323

Cost of New Common Stock = D1 / (P0 - F) + g
Cost of New Common Stock = $1.323 / ($49 - $6) + 0.05
Cost of New Common Stock = 0.0808 = 8.08%

Answer c.

Dividend, D = $1.79
Current Price, P = $30
Flotation Cost, F = $4

Cost of Preferred Stock = D / (P - F)
Cost of Preferred Stock = $1.79 / ($30 - $4)
Cost of Preferred Stock = 0.0688 = 6.88%

Answer d.

Pat Value, P = $1,000
Annual Coupon, C = 12%*$1,000 = $120
Time to Maturity, n = 6 years
Current Price, net of flotation cost, Nd = $1,270 - $40 = $1,230

Before-tax Cost of Debt = [C + {(P - Nd) / n}] / [(Nd + P) / 2]
Before-tax Cost of Debt = [$120 + {($1,000 - $1,230) / 6}] / [($1,230 + $1,000) / 2]
Before-tax Cost of Debt = $81.667 / $1,115
Before-tax Cost of Debt = 0.0732 = 7.32%

After-tax Cost of Debt = 7.32%*(1-0.35)
After-tax Cost of Debt = 4.76%

Answer e.

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Common Stock*Cost of Retained Earnings
WACC = 45%*4.76% + 25%*6.88% + 30%*7.70%
WACC = 6.17%