1. CosaNostra Pizza is undergoing a major expansion. The expansion will be financed by issuing new 26-year, $1,000 par, 9% semiannual coupon bonds. The market price of the bonds is $775 each. Flotation expense on the new bonds will be $90 per bond. The marginal tax rate is 35%. What is the post-tax cost of debt for the newly-issued bonds? 2. Fedland Inc. will issue new common stock to finance an expansion. The existing common stock just paid a $1.75 dividend, with dividends expected to grow at a constant rate of 4% indefinitely. The stock sells for $50 and flotation expenses of 4% of the selling price will be incurred on new shares. What is the cost of new common stock? Sample Questions and Solutions Sample Question: A company is expected to pay a $3.50 dividend at year-end, the dividends are expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company's WACC if all equity is from retained earnings? Solution (i) The problem assumes the stock will have a constant growth of 6.5% forever. The constant growth model is appropriate to use for this problem. The accuracy of the solution depends on the correctness of the constant growth assumption. The cost of equity assumes there will not be any new stock issuance. Therefore, the cost of equity is the cost of retained earnings for the existing shareholders. The cost of debt should be on after-tax basis due to the tax shield provided by the interest expense. (ii) The cost of equity is based on the following: Kre= (D2/Po) +g Po is the current price to be calculated, D is the next period's dividend, R is the required return on this stock g is the constant growth The cost of debt is based on ka=ra(1-T) rd is the before-tax cost of debt T is the tax rate The WACC is based on: WACC = waka+ Wrekre (iii) Cost of retained earnings = (3.5/62.5) + 0.065 = 0.121 or 12.1% Cost of debt = 7.5 x (1-0.4) = 4.5% WACC = (0.4x4.5) + (0.6x12.1) = 9.06% The average cost of capital for this company based on their existing debt and equity is 9.06%