A firm has determined its optimal capital structure which is composed of the fol

Question

A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions.

Debt: The firm can sell a 15-year, $1,000 par value, 8 percent semi-annual bond for $960. A flotation cost of
2 percent of the face value would also be required , but was not factored into the market price listed above.
Preferred Stock: The firm has determined it can issue preferred stock at $25 per share par value. The stock will pay a $2.25 annual dividend. The cost of issuing and selling the stock is $2 per share.
Common Stock: A firm's common stock is currently selling for $34 per share. The dividend expected to be paid at the end of this year is $2.74. Its dividend payments have been growing at a constant rate of 4% for the last four years. It is expected any new common stock issue would be subject to $1 per share in floatation costs.
Additionally, the firm's marginal tax rate is 35 percent.

The firm is considering a project with the following cash flows:
initial cost year 1 year 2 year 3
$5,000,000 $1,000,000 $2,000,000 $3,300,000

a) The firm's before-tax cost of newly-issued debt is ?????

b) The firm's after-tax cost of debt is ??????

c) The firm's cost of new preferred stock is ?????

d) The firm's cost of retained earnings is ???

e) The firm's cost of a new issue of common stock is ???

f) What is the firm's WACC if all new components had to be issued?????

g)Given the WACC that you calculated in the previous answer, would you accept the project that is under consideration and why? (See Table 1.) ????

Explanation / Answer

Solution: (a) Calculation of Kd before tax Kd (Before tax) = Coupon/net Proceeds = Coupon/(sale price- floating cost) = 80/(960-20) = 8.51% Kd semi-annual = 8.51/2 = 4.26% Note: (i) Coupon = 1000 * 8% = 80 (ii) Floating cost = 1000 * 2% = 20 (b) Kd (after tax) = [Coupon(1-tax)]/ [Sale price - Floating cost] = [80(1-0.35)]/ [960-20] = 52/940 = 5.53% (c ) Kp cost of prefferd stock = Divident/ proceeds net of floatingcost = 2.25/(25 - 2) = 9.78% (d) Cost of retained earning (Kr)= Ke old share = (Divident at t-1)/(price at t-0) + g = [2.74/(34) ] + 4% = 12.06% ( e) Ke new share = (Divident at t-1)/(price at t-0 - floating cost) + g = [2.74/ (34 - 1)] + 4% = 12.30% (f) Calcualtion of Wacc using new issues. Type % cost WACC Debt 30% 5.53 1.659 preffered stock 10% 9.78 0.978 equity 60% 12.3 7.38 K-o 10.017 (g) Initial cost = 5000000 Present value of inflows Year inflow PVF @ 10.017 PV 1 1000000 0.909 909000 2 2000000 0.826 1652000 3 3300000 0.751 2478300 PVCI 5039300 NPV = PVCI - PVCO = 5039300 - 5000000 = 39300 Decision : AS NPV IS POSITIVE SO ACCEPT THE PROJECT.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.