XYZ Corporation's present capital structure, which is also its target capital structure, is 40% debt ad 60% common equity. Next year's net income is projected to be $21,000 and XYZ's payout ratio is 30%. The company's earnings and dividends are growing at a constant rate of 5%; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. YXZ can raise all the debt financing it needs at 14%. If XYZ issues new common stock, a 20% flotation cost will be incurred. The firm's marginal tax rate is 40%.
a. What is the component cost of the equity raised by selling new common stock?
b. What is the maximum amount of new capital that can be raised at the lowest component cost of equity?
c. Assume (contrary to the situation in (a.) that at one point along the marginal cost of capital schedule the component cost of equity is 18%. What is the weighted average cost of capital at that point?
The solution explains how to calculate the cost of equity and WACC, as well as determines the maximum amount of new capital.