Question 1: (Cost of Capital) You are provided the following information on a company. The
total market value is $40 million. The capital structure, shown here, is considered to be
optimal.
Accounting Value
Market Value
Bonds, $1000 par, 6% coupon, 6% YTM $10,000,000
$10,000,000
Preferred Stock, 7%, $100 par, 100,000 shares $10,000,000 $8,000,000
Common Stock, $1 par, 100,000 shares $100,000
Capital in excess of pa
r $400,000
$22,000,000
* Retained Earnings
$13,500,000 *
Total market value of common equity
a. What is the after-tax cost of debt? (assume the company’s effective tax rate = 40%)
.
06*.6
=.036 or 3.6%
b. Assuming a $7 dividend paid annually, what is the required return for preferred shareholders
(i.e. component cost of preferred stock)? (assume floatation costs = $0.00)
7/80 = .0875 or 8.75%
c. Assuming the risk-free rate is 2%, the expected return on the stock market is 9%, and the
company's beta is 1.0, what is the required return for common stockholders (i.e., component cost
of common stock)?
.02 +1 x .07 = .09 or 9%
d. What is the company's weighted average cost of capital (WACC)?
Bonds
10 million
.1869 x .036 = .0067284
P.S
8 million
.1495*.0875 = .01308
35.5 million
.6636 x .09 =
.05972
Total
53.5 million
=.0795 or
7.95% WACC