Paper For Above instruction
a. Preferred Stock Component Cost
Coogly has outstanding preferred stock that pays a dividend of $4 per share and sells for $82 per share, with a floatation cost of $6 per share. The component cost of preferred stock (Kp) is calculated as the annual dividend divided by the net issuing price (price minus floatation costs):
Kp = D / (P0 - F)
Where D is the dividend per share ($4), P0 is the market price ($82), and F is the floatation cost ($6). Substituting values:
Kp = 4 / (82 - 6) = 4 / 76 ≈ 5.26%
This preferred stock component cost of approximately 5.26% provides the company's required rate of return on preferred equity investments.
Advantages of preferred stock include:
It does not dilute common equity.
It generally requires fixed dividends, making cash flow planning predictable. It typically ranks above common equity in claim hierarchy.
Disadvantages include:
Preferred dividends are not tax-deductible, unlike debt.
Issuance can be costly due to floatation costs.
can create financial risk if dividends are missed or skipped.
b. Cost of New Common Equity
The firm plans to issue new common stock at $50 per share with a floatation cost of $9, last dividend of $3.80, and a dividend growth rate of 7%. Using the Gordon Growth Model (Dividend Discount Model) adjusted for floatation costs, the cost of equity (Ke) is calculated as:
Ke = [(D1 / P0 (1 - F))] + g
Where D1 = next year's dividend = $3.80 × (1 + 0.07) = $4.066, P0 = $50, and F = 0.18 (since floatation costs are $9 on $50, or 18%), the net proceeds per share are $41.
Alternatively, the cost of new equity considering floatation costs is calculated as:
Ke = [(D1 / Pnet)] + g
Where Pnet = $50 - $9 = $41. The calculation yields:
Ke = (4.066 / 41) + 0.07 ≈ 0.099 + 0.07 = 16.9%
This indicates a relatively high cost of issuing new equity due to floatation costs and dividend growth expectations.
Advantages of issuing new equity include:
It does not increase debt levels, preserving financial flexibility.
Equity funding can enhance company reputation and investor confidence.
Disadvantages include:
It dilutes existing shareholders' ownership.
Floatation costs are significant, increasing overall capital costs.
Dividend expectations may pressure future earnings.
c. Cost of New Debt
The company will issue bonds with a market and par value of $1000, a coupon rate of 6%, floatation costs of 7%, and maturity of 20 years. The pre-tax cost of debt (Kd) is determined by adjusting the coupon rate for floatation costs and then calculating the yield to maturity (YTM).
Considering floatation, the net proceeds per bond are:
$1000 - (0.07 × 1000) = $930
The approximate cost of debt before tax is:
YTM ≈ [Coupon Payment + (Face Value - Net Proceeds) / Years] / [(Face Value + Net Proceeds)/2]
Calculating coupon payments:
$1000 × 6% = $60
Approximating YTM:
YTM ≈ [$60 + ($1000 - 930) / 20] / [(1000 + 930)/2] ≈ [$60 + 3.5] / 965 ≈ 0.0647 or 6.47%
After adjusting for tax (40%):
Kd(1 - T) = 6.47% × (1 - 0.40) = 3.88%
This is the after-tax cost of new debt, which is favorable because interest is tax-deductible.
Advantages of issuing new debt include:
Interest payments are tax-deductible, reducing overall tax liability.
Debt typically has lower cost than equity.
Maintains control without diluting ownership.
Disadvantages include:
Increased debt elevates financial risk and potential for insolvency.
Rigid obligation to make interest payments regardless of earnings.
Market conditions can influence borrowing costs.
d. Weighted Average Cost of Capital (WACC)
The WACC combines the component costs based on the company's capital structure proportions:
Equity proportion (E) = 60% (new common stock),
Preferred stock (P) = 10%,
Debt (D) = 30%.
Using the formula:
WACC = (E/V) × Ke + (P/V) × Kp + (D/V) × Kd × (1 - T)
Where V = total value = 100% or 1, and T = 40%. Substituting the calculated component costs:
WACC = 0.60 × 16.9% + 0.10 × 5.26% + 0.30 × 3.88% = 10.14% + 0.526% + 1.164% = approximately 11.83%
This WACC reflects the company's average cost of capital incorporating all sources, weighted by their proportions and considering tax benefits of debt.
Advantages of WACC include:
It provides a single hurdle rate for investment appraisal.
It considers the relative risks of each capital component.
Helps in maximizing firm value through optimal capital structure decisions.
Disadvantages include:
Assumes a constant capital structure, which may not reflect changing market conditions.
May oversimplify complex risk factors.
Reliance on accurate component cost estimations; errors can distort the WACC.
References
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Gordon, M. J. (1962). The Investment, Financing, and Valuation of Corporation Growth. IME Journal, 6(3), 255-272.
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