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Cost of capital

Cape Cod Enterprises Inc. has a capital structure consisting of $30 million in long-term debt and $20 million in common equity. There is no preferred stock outstanding.
The interest rate paid on the long-term debt is 12%. Cape Cod is in the 30% tax bracket.

On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.

Based on this information, answer the following questions.

1.Calculate Cape Cod's weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt; then, compute the cost of equity. Cite both formulas, and show all your work.

Secondly, determine the weightings of debt and equity in the capital structure.

Lastly, using your answers to the above questions, calculate the WACC.

2. If Cape Cod were to increase the weighting of debt in its capital structure, what would happen to the WACC ? No calculation is necessary- simply relay what would happen and why.

3. Identify and explain the benefits and the risks of debt in the capital structure. If a company's Rd is less than its Re, does that factor, alone, mean that the company should continue to issue more debt in order to raise capital ? Why or why not ?

Solution Preview

1.Calculate Cape Cod's weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt; then, compute the cost of equity. Cite both formulas, and show all your work.

The interest rate of debt = 12% which is the before tax cost of debt.
After tax cost = before tax cost X (1-tax rate)
After tax cost of debt = 12% X (1-0.3) = 8.4%
We use the dividend discount formula to calculate the cost of equity
Cost of equity= D1/P0 + g
where D1 = expected dividend = D0 X (1+g)
D0 = current dividend = 1.20
g = growth rate = 5%
P0= market price = $50
D1 = 1.20 X 1.05 = 1.26
Cost of equity = 1.26/50+5% = 7.52%

Secondly, determine the weightings ...

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