(Individual or component costs of capital) Compute the cost of capital for the f
ID: 2773968 • Letter: #
Question
(Individual or component costs of capital) Compute the cost of capital for the firm for the following:
a. Currently bonds with a similar credit rating and maturity as the firms outstanding debt are selling to yield 8% while the borrowing firms corporate tax rate is 34%
b. Common stock for a firm that paid a $2.05 dividend last year. The dividends are expected to grow at a rate of 5% per year into the foreseeable future. The price of this stock is now $25.
c. A bond that has a $1,000 par value and a coupon interest rate of 12% with interest paid semiannually. A new issue would sell for $1,150 per bond and mature in 20 years. The firms tax rate is also 35%.
d. A preferred stock paying a 7% dividend on a $100 par value. If a new issue is offered, the shares would sell for $85 per share.
Explanation / Answer
a)After tax debt for bond A = 8 (1 -.34)
= 8 * .66
= 5.28%
b)cost of common stock =[ D0( 1 +g) / price ] +g
= [2.05 (1 + .05) / 25 ] + .05
= [2.05 *1.05 /25] +.05
=[ 2.1525 /25 ] +.05
= .0861 +.05
= .1361 or 13.61%
c)Yield to maturity = [semiannual interest + (face value -price)/years ] /[(face value +price)/2]
= [60 + (1000 -1150 ) /40 ] /[(1000+1150)/2]
= [60 + ( -150 /40) ] / [2150/2]
= [60 - 3.75 ] / 1075
= 56.25 /1075
= 5.23 % semiannually or 5.23*12/6 = 10.46 % annually
After tax yield on bond B= 10.46 (1 -.35 )
= 10.46 * .65
= 6.80 %
**Semiannual interest = 1000*.12 *6/12 = 60
**years = 20*2 =40
d)cost of preferred stock = (100*.07 ) / 85
= 7 /85
= 8.24%
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