Echo Corporation has the following information regarding its corporate structure

Question

Echo Corporation has the following information regarding its corporate structure.

Bonds have a before cost of 8%.

They have 7% Preferred Stock with a Par value of $100. The stock was issued for $100 with issuing costs of $8 per share.

The common stock has a market price of $25 and will pay a dividend this year of $1.50 The dividend growth rate is expected to be 2% per year.

Assume the cost of retained earnings is the same as the cost of common stock.

Assume a tax rate of 25%.





The condensed balance sheet for Echo Corporation is as follows:
Assets                                                                    Liabilities
Current assets.................$400,000                        Current liabilities.....................$      50,000
Fixed assets (net)..........$1,200,000                        Long-term liabilities
Long-term assets..........$2,250,000                         8% Bonds payable...................$1,000,000
                                                              Total liabilities..........................$1,050,000
                                                              Stockholder's Equity
                                                             7% Preferred stock $100 par.....$1,200,000
                                                             Common stock............................$200,000
                                                             Retained earnings....................$1,400,000
                                                           Total Stockholder's Equity.......$2,800,000                                                     
                                                              Total liabilities and               
Total Assets...................$3,850,000                         Stockholder's equity.................$3,850,000

Requirements:
1. Determine the after-tax cost of long-term debt.
2. Determine the cost of the preferred stock.
3. Determine the cost of common stock using the constant growth model.
4. Based on your answers to requirements 1-3 and the balance sheet provided above
    calculate the weighted average cost of capital (WACC). Go out 3 decimal places.

Explanation / Answer

The cost of debt is the effective rate that a company pays on its current debt.

To get the after-tax rate, you simply multiply the before-tax rate by one minus themarginal tax rate (before-tax rate x (1-marginal tax)).

Therefore, since the question asks for the after-tax cost of debt, the third paragraph regarding the equity is extra information.

The after tax-rate of the debt will be
=12%(1 - 30%)
=12%(70%)
=8.4%

Accordingly, since the capital structure is comprised of $30M in long-term debt, the after-tax cost of debt will be
=$30M x 8.4%
=$2,520,000

The formula to use is Stock price P = D / (k-G) where:
D = Next expected dividend per share
k = Required rate of return
G = Growth rate in dividends

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