Has Target Capital Structure Of 60 Common Stock 30 Debt And 10 Preferred Stock. The Company Wishes To Issue New 30 Years Bond With 10 Coupon Rate

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The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c.

d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.

[M PI 1-13 WACC—Book weights Ridge Tool has on its books the amounts and specific (after-tax) costs shown in the following table for each source of capital.

Preferred stock 50,000 1Z.0

Common stock equity 650,000 16.0

a. Calculate the firm's weighted average cost of capital using book value weights.

b. Explain how the firm can use this cost in the investment decision-making process.

WACC—Book weights and market weights Webster Company has compiled the information shown in the following table.

^Source of capitai v'-'i.!' I""v.;. :.JM^Ket^^^uei^-y'.-'''!:cost ^

Preferred stock 40,000 60,000 13.0

Common stock equity 1,060,000 3,000,000 17.0

Totals $5,100,000 $6,900.000

a. Calculate the weighted average cost of capital using book value weights.

b. Calculate the weighted average cost of capital using market value weights.

c. Compare the answers obtained in parts a and b. Explain the differences.

WACC and target weights After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table.

:, Source of capital ■. ■''tyy'; uffiftq V^frw^g&t'

Long-term debt 30%

Preferred stock 15

Common stock equity 55

Total 100%

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of retained earnings is estimated to be 16.0%o; and the cost of new common stock is estimated to be 18.0%. All of these are after-tax rates. The company's debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock.

a. Calculate the weighted average cost of capital on the basis of historical market value weights.

b. Calculate the weighted average cost of capital on the basis of target market value weights.

c. Compare the answers obtained in parts a and b. Explain the differences.

mBQ Cost of capital and break point Edna Recording Studios, Inc., reported earnings available to common stock of $4,200,000 last year From those earnings, the company paid a dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%.

a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the company's cost of retained earnings financing?

b. If underpricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the company's cost of new common stock financing?

c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

d. The company can issue $l,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate cost of debt financing.

e. What is the maximum investment that Edna Recording Studios can make in new projects before it must issue new common stock?

f. What is the WACC for projects with a cost at or below the amount calculated in part e?

g. What is the WACC for projects with a cost above the amount calculated in part e (assuming that debt across all ranges remains at the percentage cost calculated in partd)?

U£QE2 Calculation of specific costs, WACC, and WMCC Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 40%.

Debt The firm can sell for $980 a 10-year, $l,000-par-value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond.

Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.

Common stock The firm's common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2010) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the table at the top of page 536.

2009 $3.75

2008 3.50

2007 3.30

2006 3.15

2005 2.85

It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings, a. Calculate the specific cost of each source of financing. (Assume that rr = rs.)

b. If earnings available to common shareholders are expected to be $7 million, what is the break point associated with the exhaustion of retained earnings?

c. Determine the weighted average cost of capital between zero and the break point calculated in part b.

d. Determine the weighted average cost of capital just beyond the break point calculated in part b.

Personal Finance Problem ra mQ£J Weighted average cost of capital John Dough has just been awarded his degree in •¡$4 business. He has three education loans outstanding. They all mature in 5 years and can be repaid without penalty any time before maturity. The amounts owed on each loan and the annual interest rate associated with each loan are given in the following table.

2 12,000 9

3 32,000 5

John can also combine the total of his three debts (i.e., $64,000) and create a consolidated loan from his bank. His bank will charge a 7.2% annual interest rate for a period of 5 years.

Should John do nothing (leave the three individual loans as is) or create a consolidated loan (the $64,000 question)?

mjQ£| Calculation of specific costs, WACC, and WMCC Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket.

Debt The firm can raise an unlimited amount of debt by selling $l,000-par-value, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond.

Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share. An unlimited amount of preferred stock can be sold under these terms.

Common stock The firm's common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The firm's dividends have been growing at an annual rate of 6%, and this growth is expected to continue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell an unlimited amount of new common stock under these terms.

Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

a. Calculate the specific cost of each source of financing. (Round answers to the nearest 0.1%.)

b. The firm's capital structure weights used in calculating its weighted average cost of capital are shown in the following table. (Round answer to the nearest 0.1%.)

Long-term debt 30%

Preferred stock 20

Coramo'n stock equity 50

Total 100%

(1) Calculate the single break point associated with the firm's financial situation. {Hint: This point results from exhaustion of the firm's retained earnings.)

(2) Calculate the weighted average cost of capital associated with total new financing below the break point calculated in part (1).

(3) Calculate the weighted average cost of capital associated with total new financing above the break point calculated in part (1).

EZKE2! Integrative—WACC, WMCC, and IOS Cartwell Products has compiled the data shown in the following table for the current costs of its three basic sources of capital—long-term debt, preferred stock, and common stock equity—for various ranges of new financing.

Sourcc of capital Range of new financrag : After-tax cost ji

$320,000 and above 8

Preferred stock $0 and above 17%

Common stock equity $0 to $200,000 20%

$200,000 and above 24

The company's capital structure weights used in calculating its weighted average cost of capital are shown in the following table.

Long-term debt 40%

Preferred stock 20

Common stock equity 40

Total 100%

a. Determine the break points and ranges of total new financing associated with each source of capital.

b. Using the data developed in part a, determine the break points (levels of total new financing) at which the firm's weighted average cost of capital will change.

c. Calculate the weighted average cost of capital for each range of total new financing found in part b. (Hint: There are three ranges.)

d. Using the results of part c, along with the following information on the available investment opportunities, draw the firm's weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS) on the same set of axes (total new financing or investment on the x axis and weighted average cost of capital and ERR on the y axis).

B 15 300,000

C 22 100,000

D 14 600,000

E 23 200,000

F 13 100,000

G 21 300,000

H 17 100,000

I 16 400,000

e. Which, if any, of the available investments do you recommend that the firm accept? Explain your answer.

fSef mm Integrative—WACC, WMCC, and IOS Grainger Corp., a supplier of fitness equip-■M ment, is trying to decide whether to undertake any or all of the proposed projects In its investment opportunities schedule (IOS). The firm's cost-of-capital schedule and investment opportunities schedules follow below and on page 539.

!Hi'-"'Sj^y,'Cost-of-topital Schedule ' /.v;I'•)

Range of total new finahc

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Responses

  • Gloriana
    Has a target capital structure of 30% debt, 10% preferred stock, and 60% common equity.?
    5 years ago

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