Masco Oil and Gas company is very large with common stock listed in the NYSE and bonds traded over the counter, As the current balance sheet, it has three bond issues outstanding.
1. 150 mil of 10 percent series.................2015
2. 50 mil of 7 percent series...................2009
3. 75 mil of 5 percent series..................2006
The VP of finance is planning to sell $75 million of bonds next year to replace the debt due to expire in 2006. Present market yields on similar Baa-rated bonds are 12.1%. They also have $90 million of 7.5% noncallable preferred stock outstanding, and has no intention of selling any preferred stock at any time in the future. The preferred stock is currently priced at $80 per share, and its dividend per share is $7.80.
The company has had very volatile earnings, but its dividends per share have had a very stable growth of 8% and this will continue. The expected dividend is $1.90 per share, and the common stock is selling for $40 per share. The company's investment banker has quoted the following flotation costs to Masco: $2.50 per share for preferred stock and $2.20 per share for common stock.
On the advice of its investment banker, Masco has kept its debt at 50% of assets and its equity at 50%. Masco sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. Masco's corporate tax rate is 40%.
Compute the cost of capital for the following:
A. Bond (debt) (Kd).
B. Preferred Stock (Kp).
C. Common Equity in the form of retained earnings (Ke).
D. New common stock (Kn).
E. Weighted average cost of capital
a. The before tax cost of debt will be equal to the market rate of 12.1%. This is because when the debt is raised it is based on the prevailing rates and not on the rate of debt issued earlier. That is why we take the current yield as the cost of debt. Since the interest rate is tax deductible, it is taken at after tax value
Kd = Yield (1 - T)
= 12.1% (1 - .4) = 12.1% (.6) = 7.26%
b. The fact that the preferred stock carries a coupon rate of 7.5% does not influence Kp, which is ...
The solution explains the calculation of component cost of capital and the weighted average cost of capital.