Question

COST OF CAPITAL Chambishi Milling Company (C.M.C) has the following capital Debt, 9% coupon, K1,000 Preferred stock.8% dividend. 100par Common equity.Kl par Retained earnings 15.000.000 10.000.000 5.000.0000 15.000.000 45,000,000 The company is growing very fast and management wishes to raise additional K30 000.000 to expand capacity. The money can be raised by issuing bonds, preferred stoc or common equity. Suppose the risk free rate is at 8% and the expected market return is 14% and the stock beta of 0.7: You are also aware that the company has just paid. dividend of K 1.34 and that is expected to grow at a rate of 6.0". Let us assume thoi corporate tax is 40% Required: a) Calculate the cost of debt for Chambishi milling Company b) Calculate the company cost of preferred stock c) Calculate the cost of equity using both the dividend growth model and the Security market line d) What is the tim ascrage cos! of capital?

Part not clear:
The company is growing at a fast rate and management wishes to raise additional 30,000,000 to expand capacity.

kindly remove one Zero in Common shares

Answer 1

a) Cost of Debt:

• Rate of interest: 9%
• Rate of tax: 40%
• Cost of Debt = 9% (1-40%) = 5.4%

b) Cost of Preferred Stock: 8%

c) Cost of Equity:

• Using Dividend Growth Model:
  Price = Next Dividend / (Cost of Equity - Growth)
  (K5,000,000 + K15,000,000) / 5,000,000 = (K1.34 + 6.6%) / (Cost of Equity - 6.6%)
  K1.43 / K4 + 6.6% = 6.96% [There will be rounding differences in this calculation)
• Using SML: Cost of Equity = Required Return = Risk free return+ Beta x Market Premium = 8% + 0.7 x 14% = 17.8%

d) Average Cost of Capital

• If we use Dividend Growth Model:
  6.96% x (5+15)/45 + 8% x 10/45 + 5.4% x 15/45 = 6.64%
• If we use SML:
  17.8% x (5+15)/45 + 8% x 10/45 + 5.4% x 15/45 = 11.49%

The sentence not clear to you is not relevant in solving the requirements. Anyway it just means that the company needs additional funds of K30,000,000, which they can obtain from issuing new debt, preferred stock or equity or any combination of these.