Cost of Capital – After Tax Cost of Debt, WACC, Etc.
You are provided the following information on a company. The total market value is $40 million. The capital structure, shown here, is considered to be optimal.
Accounting Value Market Value
Bonds, $1000 par, 7% coupon, 7% YTM $10,000,000 $10,000,000
Preferred Stock, 7%, $100 par, 100,000 shares $10,000,000 $8,000,000
Common Stock, $1 par, 100,000 shares $100,000
Capital in excess of par $400,000 $22,000,000 *
Retained Earnings $13,500,000
* Total market value of common equity
a. What is the after-tax cost of debt? (assume the company’s effective tax rate = 40%)
b. Assuming a $7 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume flotation costs = $0.00)
c. Assuming the risk-free rate is 3%, the expected return on the stock market is 12%, and the company’s beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company’s weighted average cost of capital (WACC)?