Home & Hearth, Inc., a chain of retail stores providing a wide selection of durable goods for the home, is considering expanding.The firm's corporate headquarters is located in Des Moines, Iowa.Recent population demographics indicate that several southern states are growing rapidly, particularly Florida and Arizona.The market value of the firm's capital structure is as follows:

Type of Financing and Market Value (in thousands)

Debt = $400

Preferred Stock = $100

Common Stock = $500

Total: $1,000

The company's outstanding bank loans have a pre-tax interest cost of 6.5%.The company uses the constant annual growth rate formula to determine the cost of equity (i.e., the Gordon constant growth stock valuation model).Home & Hearth's common stock currently trades at $85 per share.The year-end dividend ( D₁ ) is expected to be $1.50 per share, and the dividend is expected to grow forever at a constant rate of 4% per year.The company estimates that it will have to issue new common stock to help fund its expansion into Florida and Arizona.The floatation cost on new common stock issued is $2.25 per share, and the company's tax rate is 34%.The firm's preferred stock pays an annual dividend of $3.00 and has a current market value of $58.80.

1.Calculate the cost of each of Home & Hearth's sources of financing:

a.What is Home & Hearth's after-tax cost of debt financing?

b.What is Home & Hearth's cost of preferred stock financing?

c.What is the cost of Home & Hearth's new common stock equity financing?

2.What is Home & Hearth's current Weighted Average Cost of Capital (WACC), based on the cost of each type of financing that you calculated in Question #1 and the market value of the firm's current capital structure?

3.Now assume that Home & Hearth is considering a new target capital structure to allow it to expand more rapidly.The proposed target capital structure will consist of the following proportions of financing:

Type of Financing and Target % of Capital Structure

Debt=60%

Preferred Stock=10%

Common Stock= 30%

Total: 100%

Assuming this new target capital structure is adopted, what is Home & Hearth's revised Weighted Average Cost of Capital (WACC)?

4.Based on the Weighted Average Cost of Capital (WACC) that you have calculated for Home & Hearth in Question #2 and in Question #3, which capital structure do you recommend for the firm?Why?