Question

5 pts You have collected the following information regarding your company: • The company's capital structure is 70 percent equity. 30 percent debt. • The company's forecasted capital budget for the coming year is 550,000,000 • The company has 10-year bonds outstanding that have an annual coupon rate of 8.00% (paid semi-annually) and are selling at par value. New bonds will be issued as a private placement and, because total debt will increase, will require a 50 basis-point risk premium above the yield on the firm's current debt. The company's dividend next year is forecasted to be $3.90 a share. • The company expects that its dividend will grow at a constant rate of 5 percent a year. • The company's stock price is $32.50. • The company's tax rate is 40 percent. • The company anticipates that it will add $10,000,000 to its retained earnings account over the coming year, but that it will also need to raise new common stock over the year. Its investment bankers anticipate that the total flotation cost for new common stock will equal 15.00 percent of the issue price per share, and that because of downward price pressure and the issuance of additional debt, the issue price of the stock will be $2.00 less than the current price -- you may assume that the company accounts for flotation costs by adjusting the component cost of capital (i.e., it determines a price that it will net and then uses a DCF approach to determine r.). Determine the average cost of capital for the entire $50,000,000 to be raised. Enter your answer to 4-decimal places. For example, if your answer is 9.55%, enter "0.0955".

Answer 1

Answer:

Total capital requirement = $50,000,000

Target capital structure: 70% equity and 30 % debt.

Hence:

Equity required = 50000000 * 70% = $35,000,000

Out of equity required, retained earnings available = $10,000,000

Weight of retained earnings = 10000000 / 50000000 = 20%

Hence weights of capital components:

Debt = 30%

Retained earnings = 20%

New Common stock = 50%

Cost of debt:

As the bonds are selling at par value, yield = coupon rate = 8%

Before tax cost of debt = Yield + risk premium = 8% + 0.50% = 8.50%

Cost of equity (Retained earnings):

Cost of equity = (Dividend next year / Price) + growth rate = (3.90 / 32.50) + 5% = 17%

Cost of equity (new common stock):

Issue price = 32.50 - 2 = 30.50

Cost of equity (new common stock) = (Dividend next year / Issue Price (1 - Flotation cost%) + growth rate = (3.90 / (30.50 * (1 - 15%))) + 5% = 20.04%

Hence:

WACC = Cost of new common stock * weight of new common stock + Cost of retained earnings * weight of retained earnings + before tax Cost of debt * (1 - Tax rate) * weight of debt

WACC = 20.04% * 50% + 17% * 20% + 8.50% * (1 - 40%) * 30% = 0.1495 or 14.95%

WACC= 0.1495