Compute the cost of capital for the firm for the following: Currently bonds with

Question

Compute the cost of capital for the firm for the following: Currently bonds with a similar credit rating and maturity as the firm's outstanding debt are selling to yield 8.29 percent while the borrowing firm's corporate tax rate is 34 percent. Common stock for a firm that paid a $1.05 dividend last year. The dividends are expected to grow at a rate of 5.7 percent per year into the foreseeable future. The price of this stock is now $25.72. A bond that has a $1,000 par value and a coupon interest rate of 12.9 percent with interest paid semiannually. A new issue would sell for $1,153 per bond and mature in 20 years. The firm's tax rate is 34 percent. A preferred stock paying a dividend of 6.2 percent on a $110 par value. If a new issue is offered, the shares would sell for $83.46 per share.

Explanation / Answer

a)

After-tax cost of debt = Interest on debt * (100% - Corporate tax rate)

                                   = 8.29% * (100% - 34%)

                                   = 0.0829 * 0.66

                                   = 0.0547 or 5.47%

b)

Cost of common equity = Dividends per share for next year/Current market value of stock*Growth rate of dividends

                                       = (($1.05*5.7/100)/$25.72) + 5.7%

                                       = ($0.060/$25.72) + 5.7%

                                       = 0.0233 or 2.33% + 5.7%

                                       = 8.03%

c)

After-tax cost of debt:

Interest expense for annual = $129 ($1,000*12.9/100)

The interest of $129 will reduce the taxable income so there is saving in income tax at $43.86 ($129*34/100)

                                      Interest expense = $129

Less: saving in income tax from interest = $43.86

                                                    Net cost = $85.14 per year on the value of $1,000

So the after tax cost of debt is 8.514% ($85.14/$1,000*100).

d)

Cost of preferred stock:

Cost of preferred stock = Preferred dividends/Net issuing price

Net issuing price = Current issue price + New issue price

                            = $110 + $83.46

                            = $193.46

Cost of preferred stock = ($100*6.2/100)/$193.46

                                      = $6.2/$193.46

                                      = 0.0321 or 3.21%

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

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