# Cost of preferred and common equity

Bonds - The Memory Company has 10,000 bonds outstanding ($1000 face value). The bonds are selling at 101$ of face value, have a 7% coupon rate, pay interest annually, and mature in 9 years.

Preferred shares - There are 500,000 shares of 8% preferred stock ($100 stated value) outstanding with a current market price of $91 a share.

Common shares - In addition, there are 1.25 million share of common stock outstanding with a market price of $63 a share and a beta of .97. The common stock paid a total of $1.20 in dividends last year and experts to increase those dividends by 3% annually.

Other - The firm's marginal tax rate is 35%. The overall stock market is yielding 11% and the Treasury bill rate is 3.5%.

REQUIRED:

a. What is the cost of financing using preferred stock?

b. What is the cost of equity based on the dividend growth model? What is the cost of equity based on the security market line? Which is more reasonable?

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#### Solution Summary

This solution includes the computation for cost of preferred and common equity.

Finance: Cost of equity, weighted average cost of capital, cost of preferred stock

1. At the current time Warren Industries can issue 15-year, $1,000 par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each. Flotation costs of $30 per bond will be incurred in the process (which implies that f = 2.97%, or 0.0297 in decimal form) and the firm is in a 40% tax bracket.

(a) Find the net proceeds from the sale of each bond for Warren Industries.

(b) Calculate the before-tax and the after-tax cost of debt for Warren Industries.

2. Drywall Systems, Inc., is presently in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the company that different maturities will carry different coupon rates and sell at different prices. Drywall Systems must choose among several alternatives. In each case, the bonds will have a $1,000 par value and flotation costs will be $30 per bond. This implies that the firm will net $970 per bond, before the adjustment for the premium (+) or discount (-). The company is taxed at a rate of 40%. Calculate the after-tax costs of financing with each of the following alternatives.

Alternative Coupon Rate Time to Maturity Premium (+) or Discount (-)

A 9% 16 years + $250

B 7% 5 years + $50

C 6% 7 years Par

D 5% 10 years - $75

3. Gem Systems has recently issued preferred stock. The stock has a 12% annual dividend based on a par value of $100 per share. The stock is currently selling for $97.50 per share in the secondary market (so that Po = $97.50). Finally, flotation costs of $2.50 must be paid for each new share Gem Systems issues.

(a) Calculate the cost of preferred stock based on the outstanding issue, given the current market price.

(b) If Gem Systems sells a new issue of preferred stock carrying a par value of $100 but with an annual dividend of 10% of par, what is the cost of this newly issued preferred stock if the firm nets $90.00 per share after flotation costs?

4. Calculate the cost of preferred stock (rPS) for each of the following:

Preferred Stock Par Value Current Price (Po) Flotation Cost Annual Dividend

(% of Par)

A $100 $101 $9.00 11%

B $40 $38 $3.50 8%

C $35 $37 $4.00 $5.00

D $30 $26 5% of par $3.00

E $20 $20 $2.50 9%

5. JPM Corporation common stock has a beta of 1.2. The risk-free rate is 6%, and the market return is 11%.

(a) Derive the risk premium on JPM common stock.

(b) Determine JPM's cost of common equity using the CAPM.

6. Reynolds Textiles wants to measure its cost of common equity. The firm's stock is currently selling for $57.50 per share. The firm expects to pay a $3.40 dividend at the end of 2011 (so assume that

D1 = $3.40 for purposes of calculation). The dividends for the last 5 years are as follows:

Year Dividend

2010 $3.10

2009 $2.92

2008 $2.60

2007 $2.30

2006 $2.12

After incurring flotation costs, Reynolds Textiles expects to net $52 per share on a new issue.

(a) Determine the growth rate of dividends (g).

(b) By applying the constant-growth valuation model, determine the cost of retained earnings common equity (rs).

(c) By applying the constant-growth valuation model, determine the cost of newly-issued common equity (re).

7. Brite Lighting Corporation wants to investigate the effect on its cost of capital based on the rate at which the company is taxed. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14% (i.e., rs = 14%), the cost of preferred stock financing is 9% (rps = 9%), and the before-tax cost of debt is 11% (rd = 11%). Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.

(a) Tax rate = 40%.

(b) Tax rate = 35%.

(c) Tax rate = 25%.

8. Westerly Manufacturing has compiled the information shown in the following table:

Source of Capital Book Value Market Value After-tax Cost

Long-Term Debt $4,000,000 $3,840,000 6.0%

Preferred Stock $40,000 $60,000 13.0%

Common Stock Equity $1,060,000 $3,000,000 17.0%

Totals $5,100,000 $6,900,000

(a) Calculate the firm's weighted average cost of capital (WACC) using book value weights.

(b) Calculate the firm's weighted average cost of capital (WACC) using market value weights.

(c) Compare your answers found in parts (a) and (b) and briefly explain the differences. Other things equal, would you recommend that Westerly Manufacturing rely on its book value weights or market value weights in determining its WACC?

9. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano's tax rate is 40%, what component cost of debt should be used in the WACC calculation?

10. Roxie Epoxy's balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share; stockholders' required return, rs, is 10.00%; and the firm's tax rate is 40%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects?

11. Bruner Breakfast Foods' (BBF) balance sheet shows a total of $20 million long-term debt with a coupon rate of 8.00% (assume each bond to have a maturity value, M, of $1,000). The yield to maturity on this debt is 10.00%, and the debt has a total current market value of $18 million. The balance sheet also shows that that the company has 10 million shares of stock, and total of common equity (common stock plus retained earnings) is $30 million. The current stock price is $4.50 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 50% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on target, book, and market value capital structures (Note: I am asking for three (3) separate WACC values here).

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