Cost of capital The Simpson Corporation has the following items: Partial Balance
ID: 2711471 • 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
a)
b) Component Cost
Cost of Debt Using excel
=RATE(17,70,-1090,1000) = 6.13%
Cost of preferred stock = D/P = 2.2/20 = 11%
Cost of retained earnings = D1/P + g
D1 = D0 * (1 + g ) = 3 * (1 + 4%) = $3.12
Cost of retained earnings = 3.12/30 + 0.04 = 14.4%
Cost of newly issued stock = D1/P(1 -F) + g = 3.12 / 30 (1 - 8%) + 0.04 = 15.30%
c) Retained Earnigns Break Point = Retained Earnings / Cost of Retained Earnings
= 70% * 600000 / 14.4% = $2,916,666.67
d) WACC = Cost of Debt * Weight of Debt * (1 - Tax Rate) + Weight of Equity * Cost of Equity + Weight of Preferred Stock * Cost of Preferred Stock
Price Number Market Value Weight using Market Value Book Value Weight Using Book Value Bonds/Debt 1090 2000 2180000 41.29% 2000000 40% Preferred Stock 20 26000 520000 9.85% 500000 10% Common Stock 30 86000 2580000 48.86% 2500000 50%