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# Weighted average cost of capital

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5. Given the following information, calculate the weighted average cost of capital for

Situation A and Situation B:

Situation A Situation B
Capital Structure
Common Stock 55% 30%
Preferred Stock 15% 15%
Debt 30% 55%

Corporate tax rate 30% 30%
Dividend, common \$2.75 \$2.75
Price, common \$68 \$68
Dividend, preferred 10% 10%
Price, preferred \$103 \$103
Bond yield 11% 11%
Bond coupon rate 13% 13%
Flotation cost, preferred \$4.50 \$4.50
Growth rate 7.5% 7.5%

After you have calculated both weighted average cost of capital amounts, write a response that explains why the rates are different and what the advantages and disadvantages of both alternatives are.

Conclude with which capital structure you would recommend and why you selected that structure.

#### Solution Preview

Situation A and Situation B:

Situation A Situation B
Capital Structure
Common Stock 55% 30%
Preferred Stock 15% 15%
Debt 30% 55%

Corporate tax rate 30% 30%
Dividend, common \$2.75 \$2.75
Price, common \$68 \$68
Dividend, preferred 10% 10%
Price, preferred \$103 \$103
Bond yield 11% 11%
Bond coupon rate 13% 13%
Flotation cost, preferred \$4.50 \$4.50
Growth rate 7.5% 7.5%

WACC = Proportion of debt X after tax cost of debt + Proportion of preferred stock X cost of preferred stock + Proportion of common stock X cost of common stock

The costs are

After tax cost of debt = 11% X (1-0.3) = 7.7% (we take the yield and not the coupon rate since yield represents the current required return of the bond holders)
Cost of ...

#### Solution Summary

The solution explains the calculation of weighted average cost of capital for two capital structures

\$2.19

## Cost of Capital and Weighted Average Cost of Capital

1. Calculate the after-tax cost of a \$25 million debt issue that Pullman Manufacturing Corporation (40 percent marginal tax rate) is planning to place privately with a large insurance company. This long-term issue will yield 6.6 percent to the insurance company.

3. Calculate the after-tax cost of preferred stock for Bozeman-Western Airlines, Inc., which is planning to sell \$10 million of \$4.50 cumulative preferred stock to the public at a price of \$48 a share. The company has a marginal tax rate of 40 percent.

4. The following financial information is available on Fargo Fabrics, Inc.:
Current per-share market price 5 \$20.25
Current per-share dividend 5 \$1.12
Current per-share earnings 5 \$2.48
Beta 5 0.90
Expected market risk premium 5 6.4%
Risk-free rate (20-year Treasury bonds) 5 5.2%
Past 10 years earnings per share:
20X1 \$1.39 20X6 \$1.95
20X2 1.48 20X7 2.12
20X3 1.60 20X8 2.26
20X4 1.68 20X9 2.40
20X5 1.79 20Y0 2.48

7. The Ewing Distribution Company is planning a \$100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed, in part, with debt issued with a coupon interest rate of 6.8 percent. The bonds have a 10-year maturity and a \$1,000 face value, and they will be sold to net Ewing \$990 per bond. Ewing's marginal tax rate is 40 percent. Preferred stock will cost Ewing 7.5 percent after taxes. Ewing's common stock pays a dividend of \$2 per share. The current market price per share is \$35. Ewing's dividends are expected to increase at an annual rate of 5 percent for the foreseeable future. Ewing expects to generate sufficient retained earnings to meet the common equity portion of the funding needed for the expansion.
Ewing's target capital structure is as follows:
Debt = 20%
Preferred stock = 5%
Common equity = 75%
Calculate the weighted cost of capital that is appropriate to use in evaluating this expansion program.

10. The Comfort Corporation manufactures sofas and tables for the recreational vehicle market. The firm's capital structure consists of 60 percent common equity, 10 percent preferred stock, and 30 percent long-term debt. This capital structure is believed to be optimal. Comfort will require \$120 million to finance expansion plans for the coming year. The firm expects to generate enough internal equity to meet the equity portion of its expansion needs. The cost of retained earnings is 18 percent. The firm can raise preferred stock at a cost of 15 percent. First-mortgage bonds can be sold at a pretax cost of 14 percent. The firm's marginal tax rate is 40 percent. Calculate the cost of capital for the funds needed to meet the expansion goal.

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