Company X is considering changing its capital structure in light of the tough bu

Question

Company X is considering changing its capital structure in light of the tough business environment. Currently, Company X%u2019s total capital consists of:

The debt coupon is 8% and tax rate is 40%, while the current preferred share price is $96.20 and the dividend per share is $9.

The company's common stock is trading at $25.50, its dividend payout this year is $1.15, and the growth rate of the dividend is 8.5%.         

Leases are at an average cost of 8%.         

Show your calculations in detail and explain your reasoning.

Explanation / Answer

Let us see how are these numbers arrived at

(1) First column which is the amount is directly the figures from the problem, you can crosscheck.

(2) The cost of debt is given to you as 8% and the tax is 40%, this gives you a post tax cost of 8%*(1-40%) = 4.8%.Cost of leased asset is directly given 8%. cost of preferred stock is 9/96.2, that is how you get 9.4%. cost of common stock is calculated by the below mentioned formula plug in the values, it'll be 25=1.15*(1-8.5%)/(ke-8.5%). SOlve for Ke you will get 13.4%. Cost of retained earnings is 13.4%.

(3) As for the weight part multiply the respective amount by the total. For eg, weight of debt = 950/3120 * 100 = 30.4%. Similarly calculate the weights for all. finally the last column is just the multiplication of cost entries by corresponding weight entries. For eg for first row it is 4.8% * 30.4% which gives you 1.46%. Similarly calculate for all. and add them up you get WACC = 10.1%

Formulaes used

cost of debt was calculated using kd*(1-t) = 8%*(1-0.4)

Cost of preferred stock was calculated as 9/96.2

Cost of common stock usiing dividend growth model V = d*(1-g)/(ke-g) where v=25.5,g=8.5%,d=1.15

Thus WACC = 10.1%

We find that the cost of debt is minimum... So in order to lower the WACC the company can consider the option of increasing debt in its balance sheet.(keeping financial distress in mind) In other words in order to decrease the WACC the company can use more financial leverage.

Amount(mn $) cost weight cost*wt Debt 950 4.8% 30.4% 1.46% leased assets 20 8% 0.6% 0.05% prefered stock 500 9.4% 16.0% 1.50% common stock 900 13.4% 28.8% 3.86% retained earnings 750 13.40% 24.0% 3.22% Total 3120 100.0% 10.1%

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

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