CHAPTER 11 Chapter 11 The Cost of Capital 438 1. A fim has determined its optimal capital structure, which is composed of the following sources and target market value proportions: Target Market Source of Capital Proportions Long-term debt 30% Preferred stock 5 Common stock equity 65 Debt: The fim can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20. Preferred Stock: The fim has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock The fim's common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock issue must be underpriced at $1 per share and the fim must pay $1 per share in flotation costs. Additionally, the firm's marginal tax rate is 40 percent. Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained eamings. North Sea Oil has compiled the following data relative to current costs of its basic sources of external capitallong-term debt preferred stock and common stock equity-for variant ranges of financing Table 11.4 Source of Capital Cost Range of Total New Financing Long-term debt 7% $0-$2,000,000 8 $2,000,001-$3,000,000 10 $3,000,001 and above Preferred stock 19% $0-$ 960,000 21 $960,001 and above Common stock 20% $0-$ 700,000 24 $700,001-$1,600,000 26 $1,600,001-$2,200,000 30 $2,200,001 and above The fim expects to have $350,000 of current retained eamings in the coming year at a cost of 20 percent; once these retained earnings are exhausted, the fim will issue new common stock. The company's target capital structure proportions are used in calculating the weighted average cost of capital follow. Source of Capital Target Capital Structure Long-term debt 0.25 Preferred stock 0.25 Common stock equity 0.50 2. Promo Pak has compiled the following financial data: Source of Capital Book Value Market Value Long-term debt $10,000,000 $8,500,000 Preferred stock 1,000,000 1,500,000 Common stock equity 9,000,000 15,000,000 $20,000,000 $25,000,000 Cost 5.0% 14.0 20.0 3 Calculate the firm's cost of capital prior to exhausting the firm's available current retained earings. (See Table 11.4.) (a) Calculate the weighted average cost of capital using book value weights. 6) Calculate the weighted average cost of capital using market value weights. 4. Calculate the firm's cost of capital for $2,000,000 of total new financing. (See Table 11.4.) S. Given the following information on the available investment opportunities below, determine which projects should be selected. (See Table 11.4) Investment Initial InternalRate Opportunity Investment of Return A 400,000 22% B 500,000 21 400,000 19 Chapter 11 The Cost of Capital 439 D E F 400,000 600,000 700,000 17 16 16 6. A corporation is considering a capital project for the coming year. The project has an intemal rate of retum of 14 percent. If the fim has the following target capital structure and costs, what should their decision be and why? Source of Capital Proportion After-Tax Cost Long-term debt 0.40 10% Preferred stock 0.10 15% Common stock equity 0.50 20%