Chapter 10, Problem 21SP

a.

Summary Introduction

To determine: The after tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock.

Weighted Average Cost of Capital (WACC):

The Weighted Average Cost of Capital is the rate that a firm is expected to pay on average to all of its shareholders to finance its assets. WACC is the firm’s cost of capital and is dictated by the external market of the firm.

It represents the minimum return that a firm ought to earn on an existing asset base in order to satisfy its creditors, owners, and other providers of capital, or else they would invested somewhere else.

Explanation of Solution

Calculate the cost of debt.

$\begin{array}{c} \text{Cost of debt}=\text{Cost of debt before tax}\times \left(\text{1}-\text{Tax rate}\right)\\ =\text{1}0\%\times \left(\text{1}-0.\text{35}\right)\\ =\text{1}0\%\times 0.\text{65}\\ = \text{6}.\text{5}\%\end{array}$

Therefore, the cost of debt is 6.5%.

Calculate the cost of preferred stock.

$\begin{array}{c} \text{Cost of preferred stock}=\frac{\text{Preference dividend}}{\text{Price of preferred stock}}\\ \text{=}\frac{3.30}{30}\\ = \text{11}\%\end{array}$

Therefore, the cost of preferred stock is 11%.

Calculate the cost of newly issued equity stock.

$\begin{array}{c}\text{Cost of}\text{issued stock}=\left[\text{Last dividend}\times \raisebox{1ex}{$\left(\text{1}+\text{Growth rate}\right)$}\!\left/ \!\raisebox{-1ex}{$\text{Net proceeds}$}\right.\right]+\text{Growth rate}\\ =\left[\text{2}.\text{1}0\times \raisebox{1ex}{$\left(\text{1}.0\text{9}\right)$}\!\left/ \!\raisebox{-1ex}{$\left(\text{55}\times 0.\text{9}\right)$}\right.\right]+0.0\text{9}\\ =0.\text{1362}\\ = \text{13}.\text{62}\%\end{array}$

Therefore, the cost of newly issued equity stock is 13.62%.

Calculate the cost of equity from retained stock.

$\begin{array}{c}\text{Cost of equity from retained stock}=\left[\text{Last dividend}\times \raisebox{1ex}{$\left(\text{1}+\text{Growth rate}\right)$}\!\left/ \!\raisebox{-1ex}{$\text{Price of share}$}\right.\right]+\text{Growth rate}\\ =\left[\text{2}.\text{1}0\times \raisebox{1ex}{$1.09$}\!\left/ \!\raisebox{-1ex}{$55$}\right.\right]+0.0\text{9 }\\ =0.\text{1316}\\ = \text{13}.\text{16}\%\end{array}$

Therefore, the cost of equity from retained stock is 13.16%.

Conclusion

Hence, the after tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock are calculated as above.

b.

Summary Introduction

To determine: The cost of retained earnings using the CAPM method.

Explanation of Solution

Calculate the cost of retained earnings.

$\begin{array}{c}\text{Cost of retained earnings}=\text{Risk free rate}+\text{Beta}\times \text{Market risk premium}\\ =\text{6}\%+\text{1}.\text{516}\times \text{5}\%\\ = \text{13}.\text{53}\%\end{array}$

Conclusion

Hence, the cost of retained earnings is 13.53%.

c.

Summary Introduction

To determine: The cost of newly issued stock using CAPM method.

Explanation of Solution

Calculate the cost of newly issued stock.

$\begin{array}{c}\text{Cost of newly issued stock}=\left[\begin{array}{l}\text{Cost of retained earnings using CAPM method}\\ +\left(\begin{array}{l}\text{Cost}\text{of}\text{newly}\text{issued}\text{equity}\text{stock}\\ -\text{Cost}\text{of}\text{equity}\text{from}\text{retained}\text{stocks}\end{array}\right)\end{array}\right]\\ =\left[\text{13}\text{.53 + (13}\text{.62}-\text{13}\text{.16)}\right]\\ \text{=13}\text{.99\%}\end{array}$

Conclusion

Hence, the cost of newly issued stock is 13.99%.

d.

Summary Introduction

To determine: The weightage average cost of capital (WACC) from retained earnings and from newly issued stocks.

Explanation of Solution

Calculate the WACC if retained earnings are used.

$\begin{array}{c}\text{WACC}=\left(\text{6}.\text{5}0\times \raisebox{1ex}{$\text{12}00$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)\text{+}\left(\text{11}\times \raisebox{1ex}{$\text{25}0$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)+\left(\text{13}.\text{16}\times \raisebox{1ex}{$\text{135}0$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)+\left(\text{13}.\text{16}\times \raisebox{1ex}{$\text{13}00$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)\\ =\text{1}.\text{9}0\text{24}+0.\text{67}0\text{7}+\text{4}.\text{3332}+\text{4}.\text{1727}\\ =\text{11}.0\text{79 or} \text{11}.0\text{8}\%\end{array}$

Therefore, the WACC with retained earnings is 11.08%.

Calculate the WACC if newly issued stocks are used.

$\begin{array}{c}\text{WACC}=\left(\text{6}.\text{5}0\times \raisebox{1ex}{$\text{12}00$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)\text{+}\left(\text{11}\times \raisebox{1ex}{$\text{25}0$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)+\left(\text{13}.\text{16}\times \raisebox{1ex}{$\text{135}0$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)+\left(\text{13}.62\times \raisebox{1ex}{$\text{13}00$}\!\left/ \!\raisebox{-1ex}{$4100$}\right.\right)\\ =\text{1}.\text{9}0\text{24}+0.\text{67}0\text{7}+\text{4}.\text{3332}+\text{4}.3185\\ =\text{11}.2248\text{ or} \text{11}.23\%\end{array}$

Therefore, the WACC with newly issued stocks is 11.23%.

Conclusion

Hence, the weightage average cost of capital (WACC) from retained earnings and from newly issued stocks are calculated as above.