Chapter 9, Problem 9.1STP

Learning Goals 3, 4, 5, 6

ST9-1 Individual financing costs and WACC Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax bracket. The company’s financial analysts have gathered the following data:

Debt The firm can raise debt by selling $1 ,000-par-value, 10% coupon interest rate, 10-year bonds on which annual interest payments will be made. When these bonds are issued, their market price will be $970. The firm must also pay flotation costs of $20 per bond.

Preferred stock The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. Analysts expect that the cost of issuing and selling the preferred stock will be $4 per share.

Common stock The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash dividends of $6 per share next year. The firm's dividends have been growing at an annual rate of 6%, and this growth will continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs amount to $4 per share.

Retained earnings The firm expects to have $225,000 of retained earnings available in the coming year. Once the firm exhausts these retained earnings, it will use new common stock as the form of common stock equity financing.

1. a. Calculate the individual cost of each source of financing. (Round to the nearest 0.1 %.)
2. b. Calculate the firm’s weighted average cost of capital (WACC) using the weights shown in the following table, which are based on the firm's target capital structure proportions. (Round to the nearest 0.1%.)

Source of capital	Weight
Long-term debt	40%
Preferred stock	15
Common stock equity	45
Total	100%

1. c. In which, if any, of the investments shown in the following table do you recommend that the firm invest? Explain your answer. How much new financing is required?

Investment opportunity		Expected rate of return	Initial investment
A	11.2%	$100,000
B	9.7	500,000
C	12.9	150,000
D	16.5	200,000
E	11.8	450,000
F	10.1	600,000
G	10.5	300,000