Activity #6
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ScribdTranslationsActivity #6
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ScribdTranslationsIndividual costing and CCPP Lang Enterprises is interested in measuring its overall cost of capital.
Recent research gathered the following data. The company is in the 40% tax bracket.
Debt The company can raise money by selling 20-year, $1,000 par value, 8% coupon rate bonds
that pay interest annually. To sell the issue, an average of $30 per bond is discounted. The
company must also pay flotation costs of $30 per bond.
Preferred stock The company can also sell preferred stock with a par value of $95 with an annual
dividend of 8%. The cost of issuing and selling the preferred stock is expected to be $5 per share.
Preferred stock may be sold on these terms.
Common stock The Company's common stock currently sells for $90 per share. The company
expects to pay cash dividends of $7 per share next year. The company's dividends have grown at
an annual rate of 6% and this growth is expected to continue in the future. Each share should be
undervalued by $7, and flotation costs are expected to be $5 per share. The company may sell new
shares of common stock on these terms.
Retained earnings When the company measures this cost, it is not concerned about the tax level
or the owners' brokerage fees. It expects to have $100,000 of retained earnings available next
year; once retained earnings are depleted, the company will use new common stock as a form of
equity financing.
a) Calculate the cost of debt after taxes.
b) Calculate the cost of preferred stock.
c) Calculate the cost of common stock.
d) Calculate the weighted average cost of capital considering the capital structure shown in the
following table. (Round your answers to the nearest tenth of a percent).
Source of capital Weighted weight
Long-term debt 30%
Preferred stock 20
Common stockholders' equity 50
Total 100%
Solution:
a) Cost of debt Ki (approximation formula)
$ 1000−Nd
I+
n
Kd=
Nd + $ 1000
2
I = 0.08 X $ 1000 = $ 80
Nd = $ 1000 - dto bonus $ 30 - cto floatation $ 30 = $ 940
N = 20 years
$ 1000−$ 940
80+
20
Kd=
940+$ 1000
2
$ 80+ $ 3
Kd=
970
Kd=8.6 %
After-tax cost Ki
Ki=Kd x ( 1−T )
T = 40% = 0.40
Ki=8.6 % x (1−0.40)
Ki=5.2 %
b) Calculation of preferred stock Kp.
Dp
Kp=
Np
Dp = 0.08 x $ 95 = $ 7.6
Np = $ 95 - $ 5 = $ 90
$ 7.6
Kp=
$ 90
Kp=8.4 %
c) Cost of common stock Kn.
D1
Kn= +g
Nn
D1 = $ 7
Nn = $ 90 - $ 7 below market price - $ 5 float = $ 78
g = 6% = 0.06
$7
Kn= +6 %
$ 78
Kn=9 % +6 %
Kn=15 %
d)
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