Ink Inc. has target capital structure of 10% preferred stock, 50% common equity,
ID: 2760998 • Letter: I
Question
Ink Inc. has target capital structure of 10% preferred stock, 50%
common equity, and 40% debt. Ink has outstanding 20 year annual,
6% coupon bonds selling for $894. The par value of the bonds is
$1,000. Ink’s common stock sells for $50 per share and is expected
to grow at 8% and expected to pay a $2 dividend next year. If Ink
sells new common it must pay a $5 flotation fee. Ink’s preferred
stock currently sells for $95, and its annual dividend is $5 per
share. If Ink were to sell new preferred, it would pay $5 per
share as flotation cost. Ink’s tax rate is 40%.
What is Ink’s after-tax cost of debt capital?
What is Ink’s cost of preferred stock capital?
What is Ink’s cost of common stock?
What is the firm's WACC for the capital?
Explanation / Answer
Solution:
After tax cost of debt = Cost of Debt before tax x (1 – Tax Rate)
Cost of debt before tax = [Interest + (Redemption Value – Net Proceeds)/Life]/ (Redemption Value + Net Proceeds)/2 x 100
= [$60 + ($1,000 - $894)/20] / ($1,000 + $894)/2 x 100
= $65.30 / $947 x 100 = 6.90%
Cost of Debt after tax = 6.90% (1 – 0.40)= 4.14%
Cost of Preferred Stock = Preference Dividend / Net Proceeds x 100 = $5 / $90 x 100 = 5.55%
Net Proceeds = Issue Price – Floatation Cost = $95 - $5 = $90
Cost of Equity = Net Year expected dividend / Net Proceeds + growth rate
= $2 / $45 + 0.08 = 0.1244 or 12.44%
Net Proceeds = Issue Price – Floatation Cost = $50 - $5 = $45
WACC = Cost of Debt after tax x weight of debt + Cost of preferred stock x weight of preferred stock + cost of equity x weight of equity
WACC = (4.14% x 0.4) + (5.55% x 0.1) + (12.44% x 0.5) = 1.656% + 0.555% + 6.22% = 8.431%