You are an investment manager at Securities Investment PLC and you are advising the

management of Microprocessors Limited, a manufacturer of microchips, on its capital structure.

The following information is available to you to assist your assessment. The firm:

i. has issued 10% preferred share which sold for $100 per share par value. The cost of issuing

and selling the stock was $2 per share.

ii. has common share with a market price of $25 per share and an expected dividend of $2 per

share at the end of the coming year. Growth rate in dividends has been 5%.

iii. can borrow funds by selling $1 000 par value 10% coupon interest rate, 10-year debt. To

sell securities, an average discount of $30 per bond is given. Assume that the tax rate is

35%.

iv. has the following capital structure which it considers optimal:

Type of Capital Book Value

Long term debt $3 000 000

Preferred stock 500 000

Common Stock 1 200 000

Total $4 700 000

A. Determine the:

i. before and after-tax cost of debt. (4 marks)

ii. cost of preferred stock. (2 marks)

iii. cost of common stock. (2 marks)

iv. weighted average cost of capital. (4 marks)

B. The firm has a beta of 1.4. The market return equals 12% and the risk-free rate of return is

7%. Determine the firms cost of common equity using CAPM approach. (3 marks)

C. Explain why cost of capital is measured on the after-tax basis. (3 marks)

D. Why is using a weighted average cost of capital recommended rather than the cost of specific

funds to determine a firms cost of funds? (2 marks)

(Total 20 marks