II a. b. Comprehensive Cost of Capital Problem. The Triple Seven Systems, Inc. (TSS), is starting its planning process for next year. Jack Tripper, the firm's CFO, calculates the weighted cost of capital each year to be used as a discount rate in the NPV analysis. You have been asked to help Mr. Tipper to compute the firm's cost of capital. You have collected the following data to do the job: C. d. e. The capital structure for 3C Corporation is provided below. The company plans to maintain it capital structure in the future. If the firm has a 5% after-tax cost of debt, a 10% cost of preferred stock, and a 20% cost of common stock, what is 3C's weighted cost of capital? f. Capital structure Bonds Preferred stock Common stock Total $2,000,000 1,000,000 6,000,000 $9,000,000 TSS bonds carry a coupon rate of 6% with semi-annual payments, a $1,000 par, a AAA rating, and a maturity of 10 years. The current price of the TSS bonds is $950. TSS preferred stock currently pays a 10% dividend rate on a $100 par value and has a market value of $95 per share. Peer Group Firms Beta Western Pacific 1.30 TSS common shares paid a dividend of $5 last year. Dividends have grown at a rate of 6% per year and are expected to continue for a foreseeable future. The market price of the stock is $55 and there would be a flotation cost of 5% on a new issue. TSS' capital structure is as follows: Bonds (2,000 bonds outstanding) Preferred stock (10,000 shares outstanding) Common stock (600.000 shares) The firm's average tax rate is 35% and its marginal tax rate is 40%. TSS uses five companies for peer-group comparisons. These five firms along with their betas after being adjusted for financial leverage effects are as follows: 2,000,000 1,000,000 6,000,000 Peer Group Firms Southwestern, Inc Beta 1.26 1. 2. Treasury bond currently yields 3% (TRF) and the expected market return (rm) is 10%. Assignments: 3. 4. Telectroics, Inc Pacific United 5: 1.33 1.28 Ecological System, Inc. 1.18 Compute the after-tax cost of bonds. What is the cost of retained earnings, first based on the DCF approach and then based on the CAPM approach using an average beta of peer groups as TSS' beta. Calculate the average of the two approaches. What is TSS' cost of preferred stock? Calculate the cost of new stock according to the DCF approach. Calculate the weighted cost of capital for TSS assuming (a) only internal equity (retained earnings) is used in financing the equity portion of the new investment, and then (b) new common stock is issued to finance the firm's investments. 1 2 3 4 Module IX 5 6 71 8 9 Bonds 10 Preferred stock 1 Common stock 12 Total 13 4 11-1 15 16 17 11-2 18 A 19 20 21 11-3 22 11-4 23 24 11-5a 25 Bonds 26 Preferred Stock 27 Retained earnings 28 Total 29 30 11-5b 1 Bonds 32 Preferred Stock 33 New Common Stock 34 Total $ $ $ $ B Capital Structure 2,000,000 1,000,000 6,000,000 9,000,000 After-tax cost of bonds: Cost of retained earnings: Cost of preferred stock Cost of New Common Stock Amount Amount 2,000,000 1,000,000 6,000,000 9,000,000 2,000,000 1,000,000 6,000,000 9,000,000 weight Cost of Capital Spreadsheet Example Name: Date: Semi-Annual YTM= Annual YTM= Cost of Bonds= 0.22 0.11 0.67 1 DCF approach CAPM approach Average Weight Weight D cost E Cost WACC WACC Cost WACC F =SUM(E9:E11) Average beta= (