Strange Sights Paranormal Investigators Inc. has a target capital structure that

Question

Strange Sights Paranormal Investigators Inc. has a target capital structure that calls for:

40% debt

10% preferred stock

50% common equity

The firms current bonds have a before tax cost of debt of 10% and the firm is in the 40% tax bracket. The firm can sell as much debt as it wishes at this rate. The firms preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will pay flotation cost of $10 per share. Strange sights' common stock sells for $40 a share with flotation costs of $6 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10% per year. Assume the firm has sufficient retained earnings to fund the equity portion of its capital budget.

1. What is the firms cost of retained earnings? (15.5%)

2. What is the firms cost of newly issued common stock? (16.5%)

3. What is the firms cost of newly issued preferred stock? (12.5%)

4. What is the firms weighted average cost of capital? (11.7%)

The answers are giving in ( ) as a guide, I must show how I got them. Please help!!!!!

Explanation / Answer

1. Cost of retained earnings = current dividend * (1+growth rate) / current stock price + growth rate = 2 * (1+10%) / 40 + 10% = 15.5%

2. Issue price of new common stock = 40 - 6 = 34

Cost of newly issued common stock = current dividend * (1+growth rate) / issue price + growth rate = 2 * (1+10%) / 34 + 10% = 16.5%

3. Issue price of new preferred stock = 90 - 10 = 80

Cost of newly issued preferred stock = dividend / issue price = 10 / 80 = 12.5%

4. After-tax cost of debt = pretax cost * (1-tax rate) = 10% * (1-40%) = 6%

As all equity is taken care of by retained earnings, we should consider only debt and retained earnings to calculate WACC.

Weight of debt = 40%

Weight of retained earnings = 1-40% = 60%

WACC = weight of debt * aftertax cost of debt + weight of retained earnings * cost of retained earnings = 0.4 * 6% + 0.6 * 15.5% = 11.7%

Hope this helped ! Let me know in case of any queries.

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