Seminar Cost of Capital Question Compute the cost for the following

Seminar 8. Cost of Capital

Question 1. Compute the cost for the following:

a. A bond that has a $1,000 par value (face value) and a contract or coupon interest rate of 12 percent. A new issue would have a flotation cost of 6 percent of the $1,125 market value. The bonds mature in 10 years. The firm's average tax rate is 30 percent and its marginal tax rate is 34 percent.

b. A new common stock issue that paid a $1.75 dividend last year. The par value of the stock is $15, and earnings per share have grown at a rate of 8 percent per year. This growth rate is expected to continue into the near future. The company maintains a constant dividend/earnings ratio of 30 percent. The price of this stock is now $28, but 5 percent flotation costs are anticipated.

c. Internal common equity in which the current market price of the common stock is $43.50. The expected dividend this coming year should be $3.25, increasing thereafter at a 7 percent annual growth rate. The corporation's tax rate is 34 percent.

d. A preferred stock paying a 10 percent dividend on a $125 par value. If a new issue is offered, flotation costs will be 12 percent of the current price of $150.

e. A bond selling to yield 13 percent after flotation costs, but prior to adjusting for the marginal corporate tax rate of 34 percent. In other words, 13 percent is the rate that equates the net proceeds from the bond with the present value of the future cash flows (principal and interest).

Question 2. The TBTF Corporation is contemplating a new investment to be financed 35 percent from debt. The firm could sell new $1,000 par value bonds at a net price of $955. The coupon interest rate is 13 percent, and the bonds would mature in 10 years. If the company is in a 34 percent tax bracket, what is the after-tax cost of capital to TBTF for bonds?

Question 3. You are a Financial Specialist at Renco Company. Renco is planning to substitute its labelling machinery and your task is to compute the appropriate discount rate for evaluation of purchasing of the new labelling equipment. Market Values of Firm’s Capital structure are as follows:

Source of Capital	Market Values
Bonds	$5,000,000
Preferred Stock	$3,000,000
Common Stock	$8,000,000

To finance the purchase, Renco will sell 10-year bonds with $1,000 face value paying 8 percent per year at the market price of $1,110. Flotation costs for issuing the bonds are 5 percent of the market price. Preferred stock paying a $2.50 dividend can be sold for $28; the cost of issuing these shares is $4 per share. Common stock of this company is currently selling for $63 per share. The firm paid a $2.50 dividend last year and expects dividends to keep growing at a rate of 12 percent annually. Flotation costs for issuing new common stock will be $6 per share and the company’s tax rate is 34 percent. What discount rate should be used to evaluate the purchase?

Question 4. Sierra Vista Industries (SVI) wishes to estimate its cost of capital for use in analyzing projects that are similar to those that already exist. The firm’s current capital structure in terms of market value includes 40 percent debt, 10 percent preferred stock, and 50 percent common stock. The firm’s debt has an average yield to maturity of 8.3 percent. Its preferred stock has a $70 par value, an 8 percent dividend, and is currently selling for $76 per share. SVI’s beta is 1.05, the risk-free rate is 4 percent, and the return on the S&P 500 (the market proxy) is 11.4 percent. CVI is in the 40 percent marginal tax bracket.

a. What are SVI’s pretax costs of debt, preferred stock, and common stock?

b. Calculate SVI’s weighted average cost of capital (WACC) on both a pretax and after-tax basis. Which WACC should SVI use when making investment decisions?

c. SVI is contemplating a major investment that is expected to increase both its operating and financial leverage. Its new capital structure will contain 50 percent debt, 10 percent preferred stock, and 40 percent common stock. As a result of the proposed investment, the firm’s average yield to maturity on debt is expected to increase to 9 percent, the market value of preferred stock is expected to fall to its $70 par value, and its beta is expected to rise to 1.15. What effect will this investment have on SVI’s WACC? Explain your finding.