Cost of Capital

Problem 1
A firm has determined its optimal capital structure which is composed of the following sources
and target market value proportions.

Target
Source of Capital Market
Proportions
Long-term debt 20%
Preferred stock 10
Common stock equity 70

Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation
cost of 2 percent of the face value would be required in addition to the discount of $40.

Preferred Stock: The firm has determined it can issue preferred stock at $75 per share
par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the
stock is $3 per share.

Common Stock: A firm’s common stock is currently selling for $18 per share. The
dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments
have been growing at a constant rate for the last four years. Four years ago, the dividend
was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1
per share in floatation costs. Additionally, the firm’s marginal tax rate is 40 percent.

a. The firm’s before-tax cost of debt. – 7.7%

b. The firm’s after-tax cost of debt. – 4.6%
c. The firm’s cost of preferred stock. – 13.9%
d. The firm’s cost of a new issue of common stock. – 13.2% (GG)
e. The firm’s cost of retained earnings. 12.4% (GG)
f. The weighted average capital up to the point when retained earnings are exhausted is. –
10.68%
g. The weighted average capital after all retained earnings are exhausted is. – 11.24%

Problem 2
A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return
equals 6 percent. The estimated cost of common stock equity is: - 15.6%

Problem 3
Promo Pak has compiled the following financial data:
Source of Book Value Market Cost
Capital Value
Long-term debt $10,000,000 $8,500,000 5.0%
Preferred stock 1,000,000 1,500,000 14.0
Common stock 9,000,000 15,000,000 20.0
equity
$20,000,000 $25,000,000
(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.