111 1000 2 kd cost of preferred stock nd 1 t eq

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Unformatted text preview: Cost of preferred stock: Nd (1 T) [Eq. 11.2] Dp Np kp [Eq. 11.3] Cost of common stock equity: Using constant-growth valuation model: D1 P0 ks Using CAPM: ks RF [b Cost of retained earnings: kr Cost of new issues of common stock: kn g (km [Eq. 11.5] RF)] [Eq. 11.6] ks D1 Nn [Eq. 11.7] g [Eq. 11.8] Weighted average cost of capital (WACC): ka Break point: (wi ki) (wp BPj kp) AFj wj (ws kr or n) [Eq. 11.9] [Eq. 11.10] CHAPTER 11 The Cost of Capital 493 SELF-TEST PROBLEM (Solution in Appendix B) LG2 LG3 LG4 LG5 LG6 ST 11–1 Specific costs, WACC, WMCC, and IOS Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has gathered the following data: Debt The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 10% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond. Preferred stock The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. The cost of issuing and selling the preferred stock is expected to be $4 per share. An unlimited amount of preferred stock can be sold under these terms. Common stock The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash dividends of $6 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs are expected to amount to $4 per share. The firm can sell an unlimited amount of new common stock under these terms. Retained earnings The firm expects to have $225,000 of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. a. Calculate the specific cost of each source of financing. (Round to the nearest 0.1%.) b. The firm uses the weights shown in the following table, which are based on target capital structure proportions, to calculate its weighted average cost of capital. (Round to the nearest 0.1%.) Source of capital Weight Long-term debt 40% Preferred stock 15 Common stock equity Total 45 100% (1) Calculate the single break point associated with the firm’s financial situation. (Hint: This point results from the exhaustion of the firm’s retained earnings.) (2) Calculate the weighted average cost of capital associated with total new financing below the break point calculated in part (1). (3) Calculate the weighted average cost of capital associated with total new financing above the break point calculated in part (1). 494 PART 4 Long-Term Financial Decisions c. Using the results of part b along with the information shown in the following table on the available investment opportunities, draw the firm’s weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS) on the same set of axes (total new financing or investment on the x axis and weighted average cost of capital and IRR on the y axis). Investment opportunity Internal rate of return (IRR) Initial investment A 11.2% $100,000 B 9.7 500,000 C 12.9 150,000 D 16.5 200,000 E 11.8 450,000 F 10.1 600,000 G 10.5 300,000 d. Which, if any, of the available investments do you recommend that the firm accept? Explain your answer. How much total new financing is required? PROBLEMS LG1 11–1 Concept of cost of capital Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis, using the IRR decision technique, and the resulting decision actions are summarized in the following table. Basic variables Project 263 Project 264 Cost $64,000 $58,000 Life 15 years 15 years IRR 8% 15% Least-cost financing Source Debt Equity Cost (after-tax) 7% 16% Decision Action Accept Reason 8% IRR Reject 7% cost 15% IRR 16% cost a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’ best interest. b. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table. CHAPTER 11 The Cost of Capital 495 c. Had the firm used the weighted average cost calculated in part b, what actions would have been indicated relative to projects 263 and 264? d. Compare and contrast the firm’s actions with your findings in part c. Which decision method seems more appropriate? Explain why. LG2 11–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30...
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