FinCo Ltd has a beta of .85. The market risk premium is 8%, and Treasury bills are currently yielding 5%. The companys most recent dividend was $1.60 per share. Dividends are expected to grow at 6% annual rate indenitely. The stock sells for $37 per share. The cost of preferred stock is 6%, the cost of debt is 8%. The relevant tax rate is 35%. FinCo Ltd has a target capital structure of 60% common stock, 10% preferred stock, and 30% debt.

Calculate:

The best estimate of the Cost of Equity using the Dividend Growth Model (DGM) and the Capital Asset Pricing Model (CAPM)/Security Market Line (SML). (Hint: calculate Cost equity using DGM and CAPM and then take an average of both)

The Cost of Debt

The Weighted Average Cost of Capital

The President wants to know why FinCo Ltd doesnt use more preferred stock financing instead of debt because its cost is lower than debt. What would you tell the president?

The President is desirous of lowering FinCo Ltds cost of capital. What changes to the Capital Structure would you recommend and why? What other factors should be considered in arriving at the optimal capital structure?