Cost of Capital: Edna Recording Studios, Inc., reported earnings available to co
ID: 2739093 • Letter: C
Question
Cost of Capital: Edna Recording Studios, Inc., reported earnings available to common stock of $4,400,000 last year. From those earnings, the company paid a dividend of $1.23 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 25% debt, 20% preferred stock, and 55% common stock. It is taxed at a rate of 40%. A) If the market price of common stock is $33 and dividends are expected to grow at a rate of 7% per year for the foreseeable future, what is the company's cost of retained earnings financing? B) If the underpricing and flotation costs on new shares of common stock amount to $9.00 per share, what is the company's cost of new common stock financing? C) The company can issue $2.34 dividend preferred stock for a market price of $34.00 per share. Flotation casts would amount to $2.00 per share. What is the cost of perferred stock financing? D) The company can issue $1,000-par-value, 10% coupon, 8-year bonds that can be sold for $1,200 each. Flotation costs would amount to $20.00 per bond. Use the estimation formula to figure the approximate cost of debt financing. E) What is the WACC?
Explanation / Answer
a Cost of Retained Earnings :
= (Dividend (1+growth)/Market price) + growth Cost of Retained Earnings
Cost of Retained Earnings = ((1.23* (1+7%))/33) + 7%
= (1.3161/33) + 7% = 3.99% + 7% = 10.99 %
b Cost of new common stock
=( Dividend(1+growth)/Market price - floatation cost )+ growth Cost of new common stock
= (1.23*(1+7%)/(33 -9)) + 7%
Cost of new common stock = (1.3161/24) + 7% = 5.48 % + 7% = 12.48 %
c Cost of preferred stock
= Preferred stock dividend /(Market price - flotation cost)
Cost of preferred stock = 2.34 /(34-2)
Cost of preferred stock = 7.31 %
d Cost of new debt financing
= (Coupon amount + (Par value - Market price net of flotation cost)/Life of bond)/ (Market price net of flotation cost add Par Value /2)
100 + ((1000 - (1200 - 20))/5/ ((1000 + 1200 - 20)/2)
= (100-36)/1090 = 5.87 %
= 5.87%
After tax Cost of new debt financing = 5.98 (1-t) = 5.87 *0.60 = 3.52 %