Company St has a target capital structure of 35 percent of debt, 5 percent of pr

Question

Company St has a target capital structure of 35 percent of debt, 5 percent of preferred stock, and 60 percent of common stock. Its bond has a coupon interest rate of 9 percent, paid semiannually. Its preferred stocks are selling at $100. The company pays $3 quarterly dividend on its preferred stocks. The flotation cost issuing preferred stock is 5 percent. Company ST has a beta of 1.5. The risk-free rate of return is 6 percent and the market risk premium is 5 percent. Company ST grows at a constant rate of 10 percent. The company just paid an annual dividend of $5. The price its stock is $137.5. The firm’s policy is to use a risk premium of 4 percent when using the Debt cost plus risk premium method to find Ks . Flotation costs on new common stock total 10 percent, and the firm’s marginal tax rate is 40 percent.

1. What is Company ST’s after-tax cost of debt?

2. What is Company ST’s cost of preferred stock?

3. What is Company ST’s cost of retained earnings using the CAPM approach?

4. What is Company ST’s cost of retained earnings using the DCF approach?

5. What is Company ST’s cost of retained earnings using the debt cost plus risk premium approach?

6. What is Company ST’s lowest WACC?

7. What is the cost of newly issued stocks?

Explanation / Answer

1)

after-tax cost of debt = 9%*(1-40%) = 5.4%

2)

cost of preferred stock = 3*4 / (100*(1-5%)) = 12.63%

3)

retained earnings using the CAPM approach = 6% + 1.5*5% = 13.5%

4)

retained earnings using the DCF approach

137.5 = 5*(1+10%) / (r - 10%)

r = (5.5 / 137.5 ) + 10% = 14%

5)

retained earnings using the debt cost plus risk premium approach

r = 9% + 4% = 13%

6&7)

WACC is lowest when we use debt cost plus risk premium approach for equity

WACC = 35%*5.4% + 12.63%*5%* + 60%*13% = 10.32%

cost of newly issued stocks will be same as retained earnings cost of 13%

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