Calculation of individual costs and WACC Lang Enterprises is interested in measu

Question

Calculation of individual costs and WACC Lang Enterprises is interested in measuring

its overall cost of capital. Current investigation has gathered the following data.

The firm is in the 40% tax bracket.

Debt The firm can raise debt by selling $1,000-par-value, 8% coupon interest

rate, 20-year bonds on which annual interest payments will be made. To sell the

issue, an average discount of $30 per bond would have to be given. The firm also

must pay flotation costs of $30 per bond.

Preferred stock The firm can sell 8% preferred stock at its $95-per-share par

value. The cost of issuing and selling the preferred stock is expected to be $5 per

share. Preferred stock can be sold under these terms.

Common stock The firm’s common stock is currently selling for $90 per share. The

firm expects to pay cash dividends of $7 per share next year. The firm’s dividends

have been growing at an annual rate of 6%, and this growth is expected to continue

into the future. The stock must be underpriced by $7 per share, and flotation costs

are expected to amount to $5 per share. The firm can sell new common stock under

these terms.

Retained earnings When measuring this cost, the firm does not concern itself

with the tax bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year; once these retained earnings

are exhausted, the firm will use new common stock as the form of common stock

equity financing.

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the firm’s weighted average cost of capital using the capital structure

weights shown in the following table. (Round answer to the nearest 0.1%.)

Source of capital Weight

Long-term debt 30%

Preferred stock 20

Common stock equity 50

Total 100%

Explanation / Answer

a. after tax cost of debt

   kd = interest + 1/number of years (Realisabel value - net proceed)   * (1- tax)

1/2 (Realisable value + net proceed)

= 80 + 1/20 { 1000 - 940}    * (1 - 0.40)

1/2(1000+940)

= (80 + 3) / 970 * 0.60

= 5.13%

Note:- floation cost and discount are deducted from the net proceed

Net proceed = $1000 - $30 - 30

= $940

b.   the cost of preferred stock.

   kp= dividend / net proceed

   = $ 8 / $100 - $5 - $5

   = 8/ 90

   = 8.89%

Note:- preferred stock is sold at $95 per share par value (that means $5 discount {100-5 = $95}

  cost of issuing =$5

c    The cost of common stock.:

   ke = next year dividend / (current price - floatation cost)

= $7 / ($90 - $5 -$7 )

= $7 / $78

= 8.97%

d. Calculate the firm’s weighted average cost of capital :

WACC = debt percentage * kd + Equity percentage * ke + preferred percentage* kp

= 0.30 * 5.13% + 0.50 *8.97% + 0.20 * 8.89%

= 1.5% + 4.5% + 1.8%

= 7.8%

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