Written Assignment #6 - Dustin Taylor FIN-301 June 2011...

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Dustin Taylor FIN-301 June 2011 Term Written Assignment #6 Chapter 21 Problem #1 a. After-tax cost of debt 8.5% x (1 – 30%) = 5.95% b. Cost of preferred stock ($9 / $91) = 9.89% c. Cost of common stock [($.75 x 1.06) / 15] + .06 .053 + .06 = .113 or 11.3% d. Weighted-average cost of capital (0.6 x 11.3%) + (0.05 x 9.89%) + (0.35 x 5.95%) = 9.36% Problem # 2 Cost of retained earnings [$2.10(1 + .06) / $34] + .06 = 12.55% Cost of new common stock [$2.10(1 + .06) / ($34 x 93%)] + .06 = 13.04% Problem #3 a. Debt/Assets Wd After-Tax Cost of Debt We Cost of Equity Cost of Capital 0% 0 8% 1 12% 12% 10% 0.1 8% 0.9 12% 11.6% 20% 0.2 8% 0.8 12% 11.2% 30% 0.3 8% 0.7 13% 11.5% 40% 0.4 9% 0.6 14% 12% 50% 0.5 10% 0.5 15% 12.5% 60% 0.6 12% 0.4 16% 13.6%
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b. The weighted-average cost of capital is the lowest at 20% debt. This is the optimal capital structure. c. The cost of capital will decrease as a firm initially substitutes debt for equity financing. This is because the cost of debt is lower than the cost of equity. d. If a firm uses too much debt financing, the cost of capital will start to increase. Investors will start to ask for a higher required rate of return because of the higher risk of default, therefore increasing the cost of capital.
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