Intro

Honda is considering increasing production after unexpected strong demand for its new motorbike. To evaluate the proposal, the company needs to calculate its cost of capital. You've collected the following information:

• The company wants to maintain is current capital structure, which is 30% equity, 20% preferred stock and 50% debt.
• The firm has marginal tax rate of 34%.
• The firm's preferred stock pays an annual dividend of $5.2 forever, and each share is currently worth $135.26.
• The firm has one bond outstanding with a coupon rate of 6%, paid semiannually, 10 years to maturity, a face value of $1,000, and a current price of $1,163.51.
• Honda's beta is 0.5, the yield on Treasury bonds is is 3.5% and the expected return on the market portfolio is 6%.
• The current stock price is $43.68. The firm has just paid an annual dividend of $1.26, which is expected to grow by 4% per year.
• The firm uses a risk premium of 3% for the bond-yield-plus-risk-premium approach.
• New preferred stock and bonds would be issued by private placement, largely eliminating flotation costs. New equity would come from retained earnings, thus eliminating flotation costs.

Part 1

What is the (pre-tax) cost of debt?

Part 2

What is the cost of preferred stock?

Part 3

What is the cost of equity using the CAPM?

Part 4

What is the cost of equity using the constant growth model?

Part 5

What is the cost of equity using the bond yield plus risk premium?

Part 6

What is your best guess for the cost of equity if you think all three approaches are equally valid?

Part 7

What is the company's weighted average cost of capital?