Cost of capital The Simpson Corporation has the following items: Partial Balance
ID: 2446232 • Letter: C
Question
Cost of capital
The Simpson Corporation has the following items:
Partial Balance sheet for Simpson
Liabilities and Equity
A/P 525,000
Short term notes payable 1,200,000
Total Current Liabilities 1,725,000
Bonds 2,000,000
Total Liabilities 3,725,000
Preferred Stock 500,000
Common Stock 800,000
Retained Earnings 1,700,000
Total Liabilities and Equity 6,725,000
There are 2,000 bonds outstanding at a market price of $1090 per bond. The bonds mature in 17 years and have a coupon payment of $70 on the $1,000 face value of the bond.
There are 26,000shares of preferred stock outstanding at a market price of $20 per share with a $2.20 dividend. The firm expects a flotation cost of 10% on new preferred stock.
There are 86,000 shares of common stock outstanding. The market price of common stock is $30 per share with the last dividend paid (D0) of $3.00 per share the firm has an expected growth rate of 4% per year on earnings. Flotation cost on new common is 8% of sales price per share.
The firm has a marginal tax rate of 30%.
The firm estimates that it will generate net income of $600,000 for the year and will retain 70%of its earnings.
Requirements:
a. Find the 3 weights to be used to determine the cost of capital (Debt, Preferred, and Common equity weights) using market value and book values.
b. Find the component costs (%) for bonds (rd), preferred stock(rp), retained earnings(rs) and new issue common stock. (re)...
c. Find the retained earnings (Equity) break point.
d. Determine the weighted average cost of capital before and after the breakpoint using both market value and book value weights.
Explanation / Answer
Question a. Using Book Value Debt Preferred Common Total Bonds 2000000 2000000 Preferred Stock 500000 500000 Equity: 0 Common Stock 800000 800000 Retained Earnings 1700000 1700000 Total 2000000 500000 2500000 5000000 Weight 0.4 0.1 0.5 Calculations =2,000,000/5,000,000 =500,000/5,000,000 =2,500,000/5,000,000 Using Market Value Debt Preferred Common Total Bonds 2180000 2180000 Preferred Stock 520000 520000 Common Stock 800000 800000 Total 2180000 520000 2580000 3500000 Weight 0.622857 0.148571 0.737143 Calculations Same way as done previously: Question b. Debt Preferred Retaind Earnings Common stock Total Expected cost 140000 57200 170000 268320 635520 Tax Savings -42000 0 0 0 -42000 Floation cost 0 50000 206400 256400 Total Cost 98000 107200 170000 474720 849920 Component cost 4.90% 21.44% 10.0% 18.99% Question c. Break point = Retained Earnings/cost of equity =600,000*0.7/18.99% =2,211,690