Set Up: Suppose that your firm finances its investments using $15 million, $65 m

Question

Set Up:
Suppose that your firm finances its investments using $15 million, $65 million, $346 million, and $765
million in Retained Earnings, Preferred Equity, Common Equity, and Debt, respectively. Also, suppose
that your firm has a tax rate of 33%.
For Debt Financing, your firm has bonds with 7 years of maturity left, a par value of $1,000, an annual
coupon rate of 9.2%, and a current market price of $962.12. For Preferred Equity Financing, your firm's
preferred stock is worth $115.98 in the open market and pays a perpetual dividend of $21. For Common
Stock and Retained Earnings Financing, your firm's common equity paid an annual dividend last year of
$4, has a current market value of $67, and common equity dividend grow at a 10% rate per year.
Questions:
1.) Find the following:
a.) Cost of Debt Financing
b.) Cost of Preferred Equity Financing
c.) Cost of Retained Earnings Financing
d.) Cost of Common Stock Equity
2.) What is the firm's Weighted Average Cost of Capital?

Explanation / Answer

a.) Cost of Debt Financing

Before tax cost of debt = [Interest + (Par value - Net proceeds)]/1/2(Parvalue + Net Proceeds)

= [92 + (1000 - 962.12)] / 1/2(1000 - 962.12) = (92 + 37.88) / 981.06 = 129.88 /981.06 = 13.24 %

After tax cost of debt = 13.24 % x ( 1 - 0.33) = 8.87%

b)Cost of Preferred Equity Financing

Cost of Preferred equity = D/P = $21/ $115.98 = 18.106%

c.) Cost of Retained Earnings Financing

Ke = D1 / Po + g = $4, (1.1) / $67 + 10% = 6.57 + 10 = 16.57% approx

d.) Cost of Common Stock Equity

Ke = D1 / Po + g = $4, (1.1) / $67 + 10% = 6.57 + 10 = 16.57% approx

What is the firm's Weighted Average Cost of Capital?

Given, Investments are $15 million, $65 million, $346 million, and $765

million in Retained Earnings, Preferred Equity, Common Equity, and Debt, respectively.

Total Capital = 15 + 65 + 346 + 765 = 1191

% of each capital investment is as below

Retained Earnings = 15 / 1191 = 0.0126

Preferred Equity = 65 / 1191 = 0.0546

Common Equity = 346 / 1191 = 0.2905

Debt = $765 / 1191 = 0.6423

WACC = 8.87%(0.6423) + 16.57% ( 0.2905) + 18.106% (0.0546) + 16.57% (0.0126) = 11.7081 = 11.71% (approx)

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