The balance sheet that follows indicates the capital structure for Nealon Inc. F

Question

The balance sheet that follows indicates the capital structure for Nealon Inc. Flotation costs are (a) 15 percent of market value for a new bond issue, and (b) $2.01 per share for preferred stock. The dividends for common stock were $2.50 last year and are projected to have an annual growth rate of 6 percent. The firm is in a 34 percent tax bracket. What is the weighted average cost of capital if the firm’s finances are in the following proportions?
TYPE OF FINANCING
PERCENTAGE OF FUTURE FINANCING
Bonds (8%, $1,000 par, 16-year maturity)
38%
Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend)
15%
Common equity
47%
Total
100%

Explanation / Answer

Calculating the Cost of each component: Cost of debt: According to the given information, Face value of the bond = $1,000 Coupon rate = 8% Years to maturity = 16 Annual coupon payment = Face value of the bond * Coupon rate                                          = $1,000 * 0.08                                          = $80 To calculate the cost of debt we should have the current price of the bond. The question was incomplete. But still I have collected the necessary information. Basing on that Iam answering this question. Market price for bond = $1035 Market price of the bond after deducting the flotation cost = $1035 * 85%                                                                                                     = $879.75 Market price for Preferred stock = $19 Market price per share of preferred stock after deducting Flotation cost = $19 - $2.01                                                                                                                            = $16.99 Market price for Common stock = $35 CAlculating the cost of debt using excel sheet: Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" fucntion as we are finding the Cost of debt in this case. Step3: Enter the values as Nper = 16; PMT = -80; PV = 879.75; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to " 9.49%" Therefore, the pre-tax cost of debt is 9.49% Computing the after-tax cost of debt:                         After-tax cost of debt = Pre-tax cost of debt (1-tax rate)                                                          = 0.0949 (1 - 0.34)                                                          = 0.0626 or 6.26% Therefore, the after-tax cost of debt is 6.26% Computing the cost of equity: From the Dividend growth formula,                                         Re = (D1 / P0) + g                                      where D1 = D0 (1+g)                   = $2.50 (1 + 0.06)                   = $2.65             P0 = $35                g = 6% Substituting the values in the above formula, we get                                           Re = ($2.65 / $35) + 0.06                                                = 0.0757 + 0.06                                               = 0.1357 or 13.57% Therefore, the cost of equity is 13.57% Computing the cost of Preferred stock:                                        Rp = Annual preferred Dividend / Current price                                              = $1.50 / $16.99                                              = 0.0882 or 8.82% Therefore, the cost of preferred stock is 8.82% Computing the Weighted Average cost of Capital: WACC = (Wd * Cost of debt) + (We * Cost of equity) + (Wp * Cost of Preferred stock)              = (0.38 * 0.0626) + (0.47 * 0.1357) + (0.15 * 0.0882)              = 0.0238 + 0.0638 + 0.013              = 0.1006 or 10.06% Therefore, the weighted average cost of capital is 10.06%

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