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Cost of Capital

Over the past few years, My Company has been too constrained by the high cost of capital to make amny capital investmens. However, recently, capital costs have been declining, and the company has decided to look at a major expansion program.

The information below is provided to estimate the company cost of capital:

1. The company's tax rate is 40% .

2. The current price of the company's 12% coupon, semiannual payment, noncallable bond with 15 years remaining until maturity is $1,153.72 The company does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

3. The current pfirm of the company's 10%, $100 par vlaue, quarterly divident, perpetual preferred stock is $113.10. The wompany will incur flotation costs of $2.00 per share on a new issue.

4. The company's common stock is currently selling at $50 per share. Its last divident was $4.19, and dividends are expected to grow at a constant rate of 5% in the near future. The company's beta is 1.2; the yield on t-bonds is 7%; and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.

5. The company's target capital structure is 30% long-term debt, 10% preferred stock, and 6-% common equity.

Based on the above information, answer the following questions (provide step-by-step calculations):

1. What sources of capital should be included when the company's weighted average cost of capital (WACC) is estimated?

2. What is the company's weighted average cost of capital (WACC)?

3. What is the market interest rate on the company's debt and its component cost of debt?

4. What are the two primary wasy companies raise common equity? And, if the dompany doesn't plan to ussue new shares of common stock. Using the CAPM approach, what is the company's estimated cost of equity?

5. What is the cost of equity based on the bond-yield-plus-risk premium method?

6. What four common mistakes in estimating the company's WACC should be avoided?

Solution Preview

1. What sources of capital should be included when the company's weighted average cost of capital (WACC) is estimated?

The WACC is primarily used for capital budgeting decisions, which are long term in nature. Therefore the sources of capital to be included would those which would be also of long term in anture. The sources would be long term debt, preferred stock and common stock. Short term debt usually is for short term working capital and would not form a part of WACC.

2. What is the company's weighted average cost of capital (WACC)?

In order to answer this, we will have to calculate the cost of each component of capital. The cost of debt is determined in question 3 below and is 6%. The cost of preferred stock is calculated using a perpetuity model since the dividends on preferred stock are in the nature of a perpetuity. The cost is = Dividends/Market Price. The market price should be adjusted for floatation cost since if the company were to raise fresh preferred stock, the amount it would realize would be market price less the floatation cost. The dividend is 10% on $100 par value = $10. The price less floatation cost is 113.10-2 = 111.10. Cost of preferred ...

Solution Summary

The solution explains the calculation of WACC. Calculating the component cost of debt. The component cost of equity using CAPM, risk premium and the DCF method.

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