Advanced Financial Management

Chapter 9 WACC Problem

Cloak, Inc. is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket.

DEBT: The firm can raise debt by selling $1,000 par-value, 8 percent coupon interest rate, 20-year bonds on which annual interest payments will be made. The firm must pay flotation costs of $30 per bond.

PREFERRED STOCK: The firm can sell 8 percent preferred stock at its $95 per share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share.

COMMON STOCK: The firms common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The firms dividends have been growing at an annual rate of 6 percent, and this is expected to continue into the future. Flotation costs are expected to amount to $5 per share.

RETAINED EARNINGS: Cloak, Inc. expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

Instructions:

a.) Calculate the specific cost of each source of financing. (Round answers to the nearest .1 percent).

b.) Calculate the firms weighted average cost of capital assuming the use of Retained Earnings. Use the following capital structure weights:

Source of Capital Weight

Long-term debt 30%

Preferred Stock 20%

Equity* 50%

100%

c.) Calculate the firms weighted average cost of capital assuming all $100,000 of Retained Earnings has been used and new common stock must be issued.

* Weight applies to both Retained Earnings and New Common Stock.