Herbert’s business has the following capital structure: Finance Source % of Capi
ID: 2652926 • Letter: H
Question
Herbert’s business has the following capital structure:
Finance Source
% of Capital Structure
Debt (9% coupon, $1,000 par, 12 yr. to maturity)
27%
Preferred ($2 dividend, $25 par)
8%
Common equity
65%
Assume that he wants to raise capital without changing the financing proportions. The market price the current bonds is $1,075, the Preferred stock currently sells for $19 a share, and the market price of Herbert’s stock is $40, with a current dividend (D0) of $3.00 and an expected growth rate of 7%.
If the current tax rate is 40%, what would be the marginal cost of new capital if it was to come from the sale of new equity, new preferred shares, and new bonds? Assume that there are no issuance costs.
a.
10.51%
b.
11.91%
c.
11.51%
d.
12.52%
Explanation / Answer
Marginal Cost of Capital (MCC)
Marginal cost is the cost of raising one more dollar of capital. Thus this is the cost of additional fund raised. SO this is nothing but weighted average cost of additional fund raised.
Cost of Bond
Cost of bond is nothing but yield to maturity of nond.
YTM = Coupon Payment +( Face Value- Price)/n
(Face Value + Price )/2
YTM= (1000 x 0.09) + (1000-1075)/12
(1000+1075)/2
YTM= 8.06 %
Pre-tax cost of bond= 8.06 %
Cost of Preference Share
Kp= Dividend / Price
Kp= 10.53 % (2/19)
Cost of Equity
P0 = D1 / (Ke- Growth rate)
Ke= D1/P0 + G Where D1= 3 X 1.07
Ke= (3.21 / 40 ) + 0.07
Ke = 15.03
WACC =[ Kd x (1-Tax rate ) x Wd ] + Kp x WP + Ke x We
WACC =( 0.0806 x 0.6 x 0.27 ) + (0.1053 x 0.08) +( 0.1503 x 0.65)
WACC = 11.91 %
Hence Marginal cost of capital = 11.91 % ( Option B )
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