1. If the cost of new common equity is higher than the cost of internal equity,
ID: 2778111 • Letter: 1
Question
1. If the cost of new common equity is higher than the cost of internal equity, why would a firm choose to issue new common stock?
2. Calculate all MCC break points for the following information:
Total assets = $1,500,000
Total debt = $600,000
Total equity = $900,000
kd is 10% up to $500,000; 11% after $500,000
ks is 13% up to $100,000; 14% after $100,000
3. Your firm’s ks is 10%, the cost of debt is 6% before taxes, and the tax rate is 40%. Given the following balance sheet, calculate the firm’s after tax WACC:
Total assets = $25,000
Total debt = $15,000
Total equity = $10,000
4. Explain the difference between WACC and MCC.
5. What determines whether to use the dividend growth model approach or the CAPM approach to calculate the cost of equity?
Explanation / Answer
1. The cost of internal common equity would be equal to the required rate of return of the existing shareholders’. Which computed by using dividend discount model and Capital Assets Pricing Model, and in computation of cost internal common equity the cost of issue or floatation cost is excluded. Therefore, the cost external equity would be higher than the cost internal common equity.
If a firm issue new common equity then its MWCC (Marginal Weighted Cost of Capital) increases and firm accept only those projects which have IRR (Internal Rate of Return) higher than the MWCC. This helps the firm to add more dollars for shareholders maximization.
Therefore, firm prefer new common equity over internal equity.
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