Cost of Capital

The stock of IMB Computing sells for $149.89, and last years dividend was $1.50. A flotation cost of 3% would be required to issue new common stock. IMBs preferred stock pays a dividend of $3.50 per share, and new preferred stock could be sold at a price to net the company $165 per share (inclusive of flotation costs). Security analysts are projecting that the common dividend will grow at a rate of 5% a year. The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 4%, and its marginal tax rate is 32%. The market risk premium is 4%, the risk-free rate is 2.05%, and IMBs beta is 1.10. IMB is funded with a capital structure consisting of $40,000,000,000 of long-term debt, $146,000,000,000 of common equity, and $3,000,000,000 of preferred stock.

Part 1: Component Costs

A) Calculate the after-tax cost of debt.

rd
T
After Tax cost of debt

B) Calculate the cost of preferred stock.

Dps
Pps
rps

C) Calculate the cost of common equity from retained earnings. Use both the CAPM method and the dividend growth approach.

Divine Growth

Do
g
D1
Po
rs

CAPM Approach

rRF
b
RPM
rs

D) Calculate the cost of new common equity. Use both the CAPM method and the dividend growth approach. For the CAPM approach, find the difference between re and rs as determined by the dividend growth approach and add that differential to the CAPM value for rs.

Dividend Growth Approach

Do
g
D1
Po
F
re

CAPM Approach

re (from dividend growth approach)
rs (from dividend growth approach)
re - rs
re = rs (from CAPM approach above) + (re - rs)

Part 2: Capital Structure

E) Calculate the capital structure weights.

Amount funded long term debt
Amount funded short term debt
Amunt funded equity
Amount funded preferred stock
total amount funded
Wd
Wsd
Wps
Ws or We

F) Calculate the weighted average cost of capital assuming internal equity and calculate the weighted average cost of capital assuming new external equity. Perform the calculations for both the dividend growth and CAPM methods.

rs (from dividend growth approach)	rps	rd(1-T)	WACC
rs (from CAPM Approach)	rps	rd(1-T)	WACC
re (from Dividend Growth approach)	rps	rd(1-T)	WACC
re (from CAPM Approach)	rps	rd(1-T)	WACC

Part 3: Project Cost of Capital

G) Suppose IMB is evaluating three projects. Each project has a cost of $100 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from reinvested earnings.

a. (1) Equity invested in Project A would have a beta of 0.5 and an expected return of 3%.

b. (2) Equity invested in Project B would have a beta of 1.0 and an expected return of 5%.

c. (3) Equity invested in Project C would have a beta of 2.0 and an expected return of 9%.

	Beta	rs	rps	rd(1-T)	WACC	Expected return	Accept/Rejec
Project A
Project B
Project C

Identify which project should be accepted and which should be rejected.