1215

A company has the following data associated with it:

• A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
• Outstanding 20-year annual pay 6% coupon bonds selling for $894.
• Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2 dividend one year from today.
• Their $100 par preferred stock currently sells for $90 and is earning 5%.
• The company's tax rate is 40%.

What is the after tax cost of debt capital and after tax cost of preferred stock capital?

Debt Capital

Preferred Stock Capital

A) 4.2% 6.3%

B) 4.5% 5.6%

C) 4.2% 5.6%

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Debt
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT → I = 7%
k_d = (7%)(1 ? 0.4) = 4.2%

Preferred Stock
k_ps = D_ps / P
k_ps = 5 / 90 = 5.56%

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What is the weighted average cost of capital (WACC)?

A) 9.2%.

B) 10.3%.

C) 8.5%.

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k_ce = (D₁ / P₀) + g
k_ce = 2 / 45 + 0.08 = 0.1244 = 12.44%
WACC = (0.4)(4.2) + (0.1)(5.6) + (0.5)(12.4) = 8.5%

1215

Genoa Corp. is estimating its weighted average cost of capital (WACC). They have several pieces of data to consider. The firm pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year’s earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. Genoa's 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%.

The cost of common equity is closest to:

A) 13.76%.

B) 16.14%.

C) 14.19%.

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ROE × retention ratio = growth rate.

15% × (1 – 0.40) = 9%

D₀ = $5.00 × 0.40 = $2.00

[$2.00(1.09) / $42.00] + 0.09 = 14.19%

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The after-tax cost of debt is closest to:

A) 7.5%.

B) 5.3%.

C) 5.6%.

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7.5 × (1 ? 0.3) = 5.25%

1215

Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest to:

Debt

Preferred stock

A) 6.0% 12.7%

B) 10.0% 7.6%

C) 6.0% 7.6%

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After-tax cost of debt = 10% × (1 – 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.