Assume the following capital structure for XYZ Company: Debt 35% PFD 15% Common
ID: 2623248 • Letter: A
Question
Assume the following capital structure for XYZ Company:
Debt 35%
PFD 15%
Common 50%
The following facts are also provided:
Bond yield to maturity 9%
Corporate tax rate 35%
Dividend on PFD stock $8.50
Price of PFD stock $100
Float cost on PFD stock $2.00
Dividend on common stock $1.20
Price of common stock $30.00
Growth rate, common stock 9%
Compute the WACC.
IF there is $30 million in retained earnings, at what dollar value will the marginal cost of capital go up?If the float cost on common stock is $1.50, what will be the cost of new common stock?
CLUE: the marginal cost of capital will go up when there is no longer enough retained earnings to support the capital structure.
Explanation / Answer
1. Cost of debt = bond yield to maturity * (1-tax rate) = 9% * (1-35%) = 5.85%
Cost of preferred stock = dividend / (price of PFD stock - float cost) = 8.50 / (100-2) = 8.67%
Cost of common stock = (dividend / price of common stock) + growth rate = (1.20 / 30) + 9% = 13%
WACC = weight of debt * cost of debt + weight of preferred stock * cost of preferred stock + weight of common stock * cost of common stock = 35% * 5.85% + 15% * 8.67% + 50% * 13% = 9.85%
Answer: WACC = 9.85%
2. Marginal cost of capital will go up when all retained earnings are used up and we have to issue new common stock for additional capital. This will happen when total capital = retained earnings / weight of common equity, i.e. when total capital = 30 / 50% = 60 million
Cost of new common stock = (dividend / (price of common stock-float cost)) + growth rate = (1.20 / (30-1.50)) + 9% = 13.21%
Answer: Marginal cost of capital increases when total capital = 60 million
Cost of new common stock = 13.21%
Hope this helped ! Let me know in case of any queries.
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