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weighted average cost of capital

A firm has determined its optimal capital structure, which is comprised of the following sources and target market value proportions:

Source of capital target market proportions
Long term debt 30%
Preferred stock 5
Common stock equity 65

Debt: The firm can sell a 20 year, $1000 par value, 9 percent bond for $970. Interest is payable annually.

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is 3% per share.

Common Stock: The firm's common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate over the last few years. Four years ago, the dividends were $3.45 per share. It is expected that to sell a new common stock issue the firm must pay 5% in flotation costs.

Additionally, the firm's marginal tax rate is 40 percent.

What are the firm's after tax cost of debt, cost of preferred stock, cost of a new issue of common stock, cost of retained earnings, and the weighted average cost of capital (up to the point when retained earnings are exhausted and after all retained earnings are exhausted)?

Solution Preview

A firm has determined its optimal capital structure, which is comprised of the following sources and target market value proportions:

Source of capital target market proportions
Long term debt 30%
Preferred stock 5
Common stock equity 65

Debt: The firm can sell a 20 year, $1000 par value, 9 percent bond for $970. Interest is payable annually.

First, we have to find yield to maturity for the bond.

Value of bond = INT(PVIFAr,n) + PAR(PVIFr,n) where INT is the annual interest
r is the yield to maturity rate
n is the period left until maturity

970 = 90(PVIFAr, 20) + 1,000(PVIFr, 20)
= 90(PVIFAr, 20) + 1,000(PVIFr, 20)
r = 9.34%

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is 3% per share.

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Solution Summary

This solution is comprised of a detailed explanation to answer what are the firm's after tax cost of debt, cost of preferred stock, cost of a new issue of common stock, cost of retained earnings, and the weighted average cost of capital.

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