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Optimal Capital Structure for Target Market

A firm has determined its optimal capital structure that is composed of the following sources and target market value proportions:

Source of Capital Target market proportions

Long-term debt 20%
Preferred debt 10%
Common stock equity 70%

Debt: The firm can sell a 12-year, $1,000 par value, 7% bond for $960. A flotation cost of 2% of the face value would be required in addition to the discount of $40.

Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 %.

1) The firm's before-tax cost of debt is _________

7.7 %, 10.6 %, 11.2 %, or 12.7 %

2) The firm's after-tax cost of debt is ____________

3.25 %, 4.6 %, 8 %, or 8.13 %

Solution Preview

The before tax cost of debt =coupon payment / Money realized on issue
Money realized on issue= issue price - ...

$2.19