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# Cost of equity based on the security market line

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Xhat Inc has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% \$100 preferred stock outstanding with a current market price of \$83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of \$54 a share and a beta of 1.2. The common stock paid a total of \$1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm's marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.

a. What is the cost of equity based on the dividend growth model? (2)

b. What is the cost of equity based on the security market line?(2)

c. What is the cost of financing using preferred stock? (2)

d. What is the pre-tax cost of debt financing? (2)

e. What weight should be given to equity in the weighted average cost of capital computation? (2)

f. What would be the cost of new financing (including the impact of each of 28-year bonds, preferred shares and common shares), assuming that flotation costs would be 5% of the proceeds of the issue? (12)

Required the total cost of financing, not just the cost of capital for the individual pieces.

g. If net income in the next year is expected to be \$8,000,000, what would be the common equity breakpoint for new financing, assuming the current capital structure is considered optimal? (3)

#### Solution Preview

Xhat Inc has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% \$100 preferred stock outstanding with a current market price of \$83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of \$54 a share and a beta of 1.2. The common stock paid a total of \$1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm's marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.

a. What is the cost of equity based on the dividend growth model? (2)

b. What is the cost of equity based on the ...

#### Solution Summary

Response discusses cost of equity based on the security market line

\$2.19