Weighted Average Cost of Capital

23) Weighted average cost of capital (15 points) A firm's CEO has set the company's target capital structure as 50% long-term debt, 5% preferred stock, and 45% common stock equity. The firm's marginal corporate tax rate is 23 percent. To finance its planned capital expenditures, the firm is looking at the following sources of capital: Debt: The firm can sell a 20-year, $1,000 par value bond that pays an 8% coupon, with interest paid semi-annually, for $960. To issue the bond, the firm will have to pay $20 in flotation costs per bond. Preferred Stock: The firm can sell a 7.5 % preferred stock at a par value of $100 per share. The cost of issuing and selling the preferred stock is $5 per share. Common Stock: A firm's common stock is currently selling for $55 per share. This year, the firm paid $5 in dividends per share. The firm's dividends have been growing at a constant rate of 3% per year for the last four years and are expected to sustain this growth rate thereafter. New common stock issue: If the firm decides to issue new common stock, its underwriter indicated that the issue will have to be underpriced by $3 below the current share price. Further, the firm will have to pay $2 per share in flotation costs. a) Find the firm's after-tax cost of debt financing (2 points) b) Find the firm's cost of preferred stock financing (2 points) c) Find the firm's cost of financing using the retained earnings (2 points) 4 d) Find the firm's cost of financing using a new common stock issue (2 points) e) Find the firm's weighted average cost of capital, if the firm uses debt, preferred stock and retaining earnings to finance its investments (2 points) f) Find the firm's weighted average cost of capital, if the firm uses debt, preferred stock, retaining earnings, and the new stock issue to finance its investments (2 points) g) Given your findings in part (e) and (f), explain what minimum rates of return the firm must require from its long-term investments (3 points). 23) Weighted average cost of capital (15 points) A firm's CEO has set the company's target capital structure as 50% long-term debt, 5% preferred stock, and 45% common stock equity. The firm's marginal corporate tax rate is 23 percent. To finance its planned capital expenditures, the firm is looking at the following sources of capital: Debt: The firm can sell a 20-year, $1,000 par value bond that pays an 8% coupon, with interest paid semi-annually, for $960. To issue the bond, the firm will have to pay $20 in flotation costs per bond. Preferred Stock: The firm can sell a 7.5 % preferred stock at a par value of $100 per share. The cost of issuing and selling the preferred stock is $5 per share. Common Stock: A firm's common stock is currently selling for $55 per share. This year, the firm paid $5 in dividends per share. The firm's dividends have been growing at a constant rate of 3% per year for the last four years and are expected to sustain this growth rate thereafter. New common stock issue: If the firm decides to issue new common stock, its underwriter indicated that the issue will have to be underpriced by $3 below the current share price. Further, the firm will have to pay $2 per share in flotation costs. a) Find the firm's after-tax cost of debt financing (2 points) b) Find the firm's cost of preferred stock financing (2 points) c) Find the firm's cost of financing using the retained earnings (2 points) 4 d) Find the firm's cost of financing using a new common stock issue (2 points) e) Find the firm's weighted average cost of capital, if the firm uses debt, preferred stock and retaining earnings to finance its investments (2 points) f) Find the firm's weighted average cost of capital, if the firm uses debt, preferred stock, retaining earnings, and the new stock issue to finance its investments (2 points) g) Given your findings in part (e) and (f), explain what minimum rates of return the firm must require from its long-term investments (3 points)