1. Calculate the after-tax cost of a $25 million debt issue that Pullman Manufacturing Corporation (40 percent marginal tax rate) is planning to place privately with a large insurance company. This long-term issue will yield 6.6 percent to the insurance company.
After-tax Cost of Debt = 6.6% × (1- T)
= 6.6% × (1- 0.4)
= 3.96%
- The Ewing Distribution Company is planning a $100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed, in part, with debt issued with as coupon interest rate of 6.8 percent. The bonds have a 10-year maturity and a $1,000 face value, and they will be sold to net Ewing $990 per bond. Ewing's marginal tax rate is 40 percent.
Preferred stock will cost Ewing 7.5 percent after taxes. Ewing's common stock pays a dividend of $2 per share. The current market price per share is $35. Ewing's dividends are expected to increase at an annual rate of 5 percent for the foreseeable future. Ewing expects to generate sufficient retained earnings to meet the common equity portion of the funding needed for the expansion. Ewing's target capital structure is as follows:
Debt = 20%
Preferred stock = 5%
Common equity = 75%
Calculate the weighted cost of capital that is appropriate to use in evaluating this expansion program.
Cost of debt:
$990 =
kd = 6.9% by calculator
kd = 6.9% (1 - 0.4) = 4.1%
kp = 7.5%
ke .11or 11%
ka = 0.2(4.1%) + 0.05(7.5%) + 0.75(11%) = 9.4%
10. The Comfort Corporation manufactures sofas and tables for the recreational vehicle market. The firm’s capital structure consists of 60 percent common equity, 10 percent preferred stock, and 30 percent long-term debt. This capital structure is believed to be optimal. Comfort will require $120 million to finance expansion plans for the coming year. The firm expects to generate enough internal equity to meet the equity portion of its expansion needs. The cost of retained earnings is 18 percent. The firm can raise preferred stock at a cost of 15 percent. First mortgage bonds can be sold at a pretax cost of 14 percent. The firm’s marginal tax rate is 40 percent.
Calculate the cost of capital for the fund needed to meet the expansion goal.
ki = kd (1 - T) = (14%)(1 - 0.4) = 8.4%
ka = 0.3(8.4%) + 0.10(15%) + 0.6(18%) = 14.8%
12. Rolodex Inc would like to estimate its average cost of capital for the coming year. The capital budgeting plans call for funds totaling $200 million for the coming year. The capital budgeting plans call for funds totaling $200 million for the coming year. These funds will be raised from long-term debt, preferred stock, and common equity in the same proportions as their book values in the firm’s balance sheet shown below:
Rolodex, Inc. Balance Sheet (in millions of dollars) .
Current assets$100Accounts payable$30
Fixed assets 260Other current liabilities 20
Total assets$370Long-term debt 128
Preferred Stock 32
Common stock (20 million shares at par) 20
Contributed capital in excess of par 30
Retained earnings 110
Total liabilities and equity$370
Discussions between the firm's financial officers and the firm'sinvestment and commercial bankers have yielded the following information:
- Rolodex’s maximum borrowing is $80 million from its bank at a pretax cost of 13 percent.
- Preferred stock can be issued at a pretax cost of 16.5 percent.
- Rolodex expects to generate $140 million in net income. Any earnings remaining after meeting the equity portion of the $200 million capital expenditure budget will be paid out as dividends.
- The risks free rate of return is 5.5 percent. The market risk premium is assumed to equal 10 percent and Rolodex’s beta is estimated to be 1.2.
- Rolodex’s marginal tax rate is 40 percent.
Compute Rolodex’s weighted average cost of capital for the coming year.
Calculate book value proportions of debt, preferred stock and common equity in the capital
structure:
Total capital = long term debt + preferred stock common equity = $128 mill. + $32 mill + $20 mill. + 30 mill. + $110 mill. = $320 mill.
Proportion of debt = $128 mill. / $320 mill. = .40 or 40%
Proportion of preferred stock = $32 mill. / $320 mill. = .10 or 10%
Proportion of common equity = $160 mill. / $320 mill. = .50 or 50%
ki = kd (1 - T) = (13%)(1 - 0.4) = 7.8%
ke = 5.5% + (10%) 1.2 = 0.175 or 17.5%
ka = 0.4(7.8%) + .10(16.5) + 0.5(17.5%) = 13.5%