Alpha Products plans to finance its capital budget for next year by selling $50

ID: 2637080 • Letter: A

Question

million of 11 percent coupon rate bonds, with each bond having a maturity value (M) of $1,000

and a 15-year maturity. Flotation costs (F) will be 4% of the maturity value of each bond. The

balance of its $125 million capital budget will be financed with retained earnings (so that

retained earnings will be at least $75 million next year). Next year Alpha expects dividends will

increase at a 6.8 percent rate to $1.40 per share (so that D1 = $1.40), and the CFO expects

dividends and earnings to continue growing at the 6.8 percent rate for the foreseeable future. The

current market value of Alpha's stock is $28. The firm has a marginal tax rate of 35 percent.

Given its flotation cost on newly issued debt what is the cost of debt for Alpha Products (rd)?

What is the cost of retained earnings equity capital for Alpha Products (rs)? Finally, what is its

weighted average cost of capital for the coming year (only use next year

1. Cost of Debt: 11% + 4% Flotation cost adjustment

PV Factor at 11% for 15 Years = 0.209

Cost of Debt = 110 / 952 (1000 - 40 - 40 x 0.209) = 11.55%

Interest Payment will give advantage in tax payment. Tax = 35%

Cost of Debt = 0.1155 x (1-0.35) = 7.51%

Total Cost of Debt = 7.51%

Cost of Retained Earning Equity Capital = D1 / Market Price + Dividend Growth rate

D1 = $1.40, Market Price = $28, Growth Rate = 6.8%

Cost of Equity = 1.40 / 28 + 0.068

Cost of Retained Earning Equity Capital = 11.80%

Proportion of Debt = 50/125 = 40%, Proportion of Equity = 75/125 = 60%

Weighted Average Cost of Capital = (0.40 x 0.0751) + (0.60 x 0.1180)

= 0.10084 or 10.084%

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