Capestone: Pls help me to slove the below question Thank you Adams Corp. is esti

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Capestone:

Pls help me to slove the below question

Thank you

Adams Corp. is estimating their cost of capital. Their stock sells for $55, and last year’s dividend was $2.10. A flotation cost of 10% of proceeds would be required to issue new common stock. Security analysts are projecting that the common dividend will grow at a rate of 7% a year forever. Adams’ preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share. The firm can also issue long-term debt with a coupon of 10% at par value with no flotation costs. The firm’s tax rate is 35%, market risk premium is 6%, risk-free rate is 6.5%, and beta is 0.83. The firm uses a target capital structure of 45% debt, 5% preferred stock, and 50% common equity. Adams expects to generate total earnings of $1,400,000 over the next year, of which it will pay out 55% as dividends.

a) Compute Adams’ before-tax and after-tax costs of debt.

b) Compute Adams’ cost of preferred stock.

c) If Adams generates sufficient internal cash flow, and does not need to issue new external stock to generate equity capital, what is the average cost of internal equity for the firm? {Hint: Use as many methods to estimate this cost as the information will allow you to do.}

d) Compute Adams’ average cost of external equity.

e) Compute the firm’s WACC before and after it exhausts all its retained earnings.

f) What is the firm’s retained earnings breakpoint

Explanation / Answer

(a) Debt = Firm's Long-Term Bonds

Coupon Rate for Bonds = Bond Yield = Cost of Debt (before-tax) = 10 % ( because bonds are issued at par value)

Before-Tax Cost of Debt = 10 %

Tax Rate = 35 %

After-Tax Cost of Debt = 10 x (1-0.35) = 6.5 %

(b) Preferred Stock Dividend = $ 3.3 and Market Value of Preferred Stock = $ 30

Cost of Preferred Stock = (3.3 / 30) x 100 = 11 %

(c) Cost of Internal Equity can be calculated using the constant dividend growth model and the CAPM.

Dividend Growth Model:

Current Market Price = P0 = $ 55 and Latest Dividend = D0 = $ 2.1

Dividend Growth Rate = g = 7 %

Expected Dividend = 2.1 x (1.07) = $ 2.247

Therefore, cost of equity = r1 = (D1/P0) + g = (2.247 / 55) + 0.07 = 0.11085 or 11.085 %

CAPM:

Risk Premium = 6 % and Risk Free Rate = 6.5 %

Beta = 0.83

Cost of Equity = r2 = 6.5 + 0.83 x 6 = 11.48 %

Average Cost of Internal Equity = (r1 + r2) / 2 = (11.085 + 11.48) / 2 = 11.2825 %

(d) The external cost of equity will change owing to the change in the value of cost of equity calculated using the constant dividend growth model. The CAPM rate should remain the same.

Flotation Cost = 10 %

Therefore, new r1 = (2.247 / 55 x (1-0.1)) + 0.07 = 0.1154 or 11.54 %

Average Cost of External Equity = (new r1 + r2) / 2 = (11.54 + 11.48) / 2 = 11.51 %

NOTE: Please raise separate queries for solutions to the remaining sub-parts as one query allows asnwering only the first four sub-parts.

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