You develop the following information. Your firm has a target capital structure

Question

You develop the following information. Your firm has a target capital structure of 80% common equity, 5% preferred stock and 15% debt. The firm’s tax rate is 25%.

The firm can issue up to $225,000 worth of debt at a before-tax cost of 10%. Then it will cost the firm 11.5% before-tax on debt up to $300,000. After that point, the after-tax cost of debt will be 9.75%.

The firm’s preferred stock carries an annual dividend of $1.75 per share. The issue price of the preferred would be $20 with 2% of the issue price charged as flotation costs. The firm can use up to $125,000 of this preferred stock before the cost will increase to 10%.

The firm expects to have $1,500,000 in earnings and have a dividend payout ratio of 30%. The firm bases its cost of retained earnings on the CAPM approach. For this purpose, you determine the growth rate of the market will be 6% and the market dividend yield is 8%. The risk-free rate is 2.50%. The firm’s beta is 0.80.

The firm can issue new common stock with a $1.00 dividend, price of $25 per share, flotation costs of 4% of issue price and growth rate expected of 8%. This holds for up to $1,400,000 in equity after which it will cost 13% for new common stock.

Determine the marginal cost of capital schedule.

Explanation / Answer

Weight of equity = We = 0.8

Weight of preferred stock = Wpf = 0.05

Weight of debt = Wd = 0.15

Suppose the firm wants to raise 1,000,000 (1 million) - 800,000 will be stocks, 50,000 will be preferred stock and 150,000 will be debt

So assuming this capital structure, the cost of debt for the first 225,000 will be 10%. Hence the After tax cost of debt will be = 10*(1-0.25) = 7.5%. (Rd = 7.5%)

Cost of preferred shares will be Dividend/ Price of preferred share = 1.75/ 20*(1-0.02) = 1.75/ 19.6 = 0.0893 =8.93%. (Rpf = 8.93%)

The cost of equity as per CAPM = Re = Rf + beta*(Rm -Rf)

Rf = 2.5%, beta = 0.8 and Rm = 8 + 6 =14%

Re = 2.5 + 0.8(14-2.5) = 11.7%

So Marginal Cost of capital = We* Re + Wpf * Rpf + Wd * Rd

Marginal Cost of capital = 0.8* 11.7 + 0.05 * 8.93 + 0.15 * 7.5 = 10.93%

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