Southern Corporation has a capital structure of 40% debt and 60% common equity.
ID: 2745734 • Letter: S
Question
Southern Corporation has a capital structure of 40% debt and 60% common equity. This capital structure is expected not to change. The firm's tax rate is 34%. The firm can issue the following securities to finance capital investments: Debt: Capital can be raised through bank loans at a pretax cost of 8.5%. Also, bonds can be issued at a pretax cost of 10%. Common Stock: Retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $59. Flotation costs will be $3 per share. The recent common stock dividend was $3.15. Dividends are expected to grow at 7% in the future. What is the cost of capital if the firm uses bonds and issues new common stock?
Explanation / Answer
After tax cost of Issuing Bond = 10% * (1-0.34) = 6.6% or 0.066
Cost of Issuing New Common Stock = D0 (1+g) / Po- floatation Cost + g
=$3.15(1.07)/$59 -$3 +0.07
=$3.3705/$56 +0.07
=0.13019 or 13.019%
Cost of Capital WACC of the firm = KE*WE+ DE*WE
= 0.6*0.13019 +0.4* 0.066
= 0.104551 or 10.45%
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