# Calculating cost of capital

An analyst is attempting to determine the weighted average cost of capital for Coleslaw, Inc. The analyst has determined that Coleslaw has 3,000,000 shares of common stock outstanding, priced at $32 per share. The stock's beta is 0.90. The analyst expects that shares will pay a dividend of $2.00 next year, and that dividends will grow at 6.00%.

The company faces a tax rate of 40%. The risk less rate is 3%, and the analyst believes the expected return on the stock market is 11%.

The company has issued 325,000 shares of preferred stock, with a par value of $105.00, paying a dividend of $6.30. The preferred shares are currently selling at $98.00 each.

The company has two outstanding bond issues. The first is a 10-year zero coupon bond with a face value of $42,000,000, currently priced at $20,378,145. The second bond issue matures in 5 years, has a 5.50% coupon rate, an $80,000,000 face value, and a yield to maturity of 6.25%.

Questions.

1. Based on CAPM, what is the after-tax cost of common equity for Coleslaw, Inc.?

2. Based on the constant-growth dividend discount model, what is the after-tax cost of common equity for Coleslaw, Inc.?

3. What is the after-tax cost of preferred equity for Coleslaw, Inc.?

4. What is the after-tax cost of Coleslaw's zero coupon debt?

5. What is the after-tax cost of Coleslaw's 5-year bond?

6. What is the total dollar amount of Coleslaw's capital?

7. What is the weight of common equity in Coleslaw's capital structure?

8. What is Coleslaw's weighted average cost of capital (WACC), using the CAPM-based cost of common equity?

#### Solution Preview

Please refer attached file for better clarity of expressions.

1. Based on CAPM, what is the after-tax cost of common equity for Coleslaw, Inc.?

Risk free rate=rf=3%

Expected market return=rm=11%

Stock's beta=b=0.9

Rate of return on stock=r=?

r=rf+b*(rm-rf)=3%+0.9*(11%-3%)=10.20%

After tax cost of common equity, rc=rate of return on stock=10.20%

2. Based on the constant-growth dividend discount model, what is the after-tax cost of common equity for Coleslaw, Inc.?

Expected dividend next year=D1=$2.00

Growth rate=g=6%

Current Price of stock=Po=$32

Required rate of return=r=?

Constant growth model gives us ...

#### Solution Summary

Solution describes the methodology to find out the cost of various components of capital. It also calculates weighted average cost of capital.