Question

3. ABC, Inc. is looking at raising additional capital for a future project. The project is expected to provide a return on investment of 13. In order for ABC, Inc. to determine whether this project is worth investing in, it must first determine the cost of the capital it will use to finance the project (20 total points) a. The firm's current stock price is $45 and it has 4 million shares of stock outstanding. The firm also has $30 million of preferred stock and 570 million of debt. Calculate the weights of each capital component. (2 points) Val Short 180 Vai PMS I : 70 qual , 770 6. The firm is looking at issuing a new 30-year bond that pays an annual coupon of 8% with a flotation cost of 2%. The bond is expected to sell at its par value of $1,000. The firm's tax rate is 40%. Calculate the ATr.. (4 points) c. The firm will have to pay the underwriter a 10% flotation cost for the new equity it will raise. The firm just paid out a dividend of $4.22 with an expected growth rate of 4.5%. Calculate the re(4 points) d. The firm expects its preferred stocks to sell for $112.55. The par value of the preferred stock will be $100 with a 12% annual dividend. The flotation cost that will be paid to the underwriter will be 4%. Calculate the fa- (4 Points) e. Assuming that the firm's current market value is their target capital structure, what is the firm's WACC? (4 points) 1. Should the firm take on this investment based on the cost of the capital that it will use to fund the project? Why? (2 points)

Answer 1

a]

Value of common stock = shares outstanding * price per share = 4,000,000 * $45

Value of common stock = $180,000,000.

Value of preferred stock = $30,000,000.

Value of debt = $70,000,000.

Total value =  $180,000,000 + $30,000,000 + $70,000,000.

Total value =  $280,000,000.

Weight of common stock = Value of common stock / Total value =  $180,000,000 / $280,000,000 = 0.643.

Weight of preferred stock = Value of preferred stock / Total value =  $30,000,000 / $280,000,000 = 0.107.

Weight of debt = Value of debt / Total value =  $70,000,000 / $280,000,000 = 0.250.

b]

The bond will be sold at par. Hence, its yield equals its coupon rate.

Before-tax cost of debt (net of flotation cost) = yield / (1 - flotation cost)

Before-tax cost of debt (net of flotation cost) = 8% / (1 - 2%) = 8.16%.

After-tax cost of debt = Before-tax cost of debt * (1 - tax rate)

After-tax cost of debt = 8.16% * (1 - 40%) = 4.90%.

c]

cost of equity = (next year dividend / net proceeds per share) + growth rate.

next year dividend = last dividend * (1 + growth rate)

next year dividend = $4.22 * (1 + 4.5%) = $4.41

net proceeds per share = price of share - flotation cost

net proceeds per share = $45 - ($45 * 10%) = $40.50.

cost of equity = ($4.41 / $40.50) + 4.5%

cost of equity = 15.39%

d]

cost of preferred stock = (annual dividend / net proceeds per share)

annual dividend = face value * dividend rate = $100 * 12% = $12.

net proceeds per share = price of share - flotation cost

net proceeds per share = $112.55 - ($112.55 * 4%) = $108.05

cost of preferred stock = $12 / $108.05 = 11.11%