Question

Question: Brook’s Window Shields Inc. is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. Glass, the vice president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with a 12.2 percent coupon rate and another bond with a 9.5 percent coupon rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 13.4 percent.

The common stock has a price of \(58 and an expected dividend (D1) of \)5.30 per share. The firm’s historical growth rate of earnings and dividends per share has been 9.5 percent, but security analysts on Wall Street expect this growth to slow to 7 percent in future years.

The preferred stock is selling at \(54 per share and carries a dividend of \)6.75 per share. The corporate tax rate is 35 percent. The flotation cost is 2.1 percent of the selling price for preferred stock. The optimum capital structure is 40 percent debt, 25 percent preferred stock, and 35 percent common equity in the form of retained earnings.

Compute the cost of capital for the individual components in the capital structure, and then calculate the weighted average cost of capital (similar to Table 11-1).

Short answer

Answer

Cost after tax:

Particular	Cost after tax
Debt	8.71%
Common stock	18.64%
Preferred stock	12.77%

Weighted average cost:

Particular	Weighted Cost
Debt	3.48%
Common stock	6.52%
Preferred stock	3.19%

Step-by-step solution

Definition of Cost of Capital

The metric determining the minimum return a business entity must create to cover the cost incurred in the capital project is known as the cost of capital.

Calculation of cost of capital

Particular	(1) Cost after tax	(2) Weights	(3) Weighted Cost
Debt	8.71%	40%	3.48%
Common stock	18.64%	35%	6.52%
Preferred stock	12.77%	25%	3.19%

Working note:

1. Calculation of cost of debt after tax:

$$\begin{gathered} {\mathit{K}}_{\mathbf{d}}\mathbf{=}\mathit{Y}\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{T}\mathbf{)} \\ \mathbf{=}\mathbf{13}\mathbf{.}\mathbf{4}\mathbf{\%}\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{35}\mathbf{)} \\ \mathbf{=}\mathbf{8}\mathbf{.}\mathbf{71}\mathbf{\%} \end{gathered}$$

2. Calculation of cost of preferred stock:

$$\begin{gathered} {\mathit{K}}_{\mathbf{P}}\mathbf{=}\frac{{\mathbf{D}}_{\mathbf{P}}}{{\mathbf{P}}_{\mathbf{p}}\mathbf{-}\mathbf{F}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{6}\mathbf{.}\mathbf{75}}{\mathbf{\$}\mathbf{54}\mathbf{-}\mathbf{(}\mathbf{\$}\mathbf{54}\mathbf{\times }\mathbf{2}\mathbf{.}\mathbf{1}\mathbf{\%}\mathbf{)}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{6}\mathbf{.}\mathbf{75}}{\mathbf{\$}\mathbf{54}\mathbf{-}\mathbf{\$}\mathbf{1}\mathbf{.}\mathbf{134}} \\ =12.77\% \end{gathered}$$

3. Calculation of cost of common stock:

$$\begin{gathered} {\mathit{K}}_{\mathbf{e}}\mathbf{=}\frac{\mathbf{C}\mathbf{u}\mathbf{r}\mathbf{r}\mathbf{e}\mathbf{n}\mathbf{t}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}}{\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{k}\mathbf{e}\mathbf{t}\mathbf{p}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}}\mathbf{+}\mathit{G}\mathit{r}\mathit{o}\mathit{w}\mathit{t}\mathit{h}\mathit{r}\mathit{a}\mathit{t}\mathit{e} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{5}\mathbf{.}\mathbf{30}}{\mathbf{\$}\mathbf{58}}\mathbf{+}\mathbf{9}\mathbf{.}\mathbf{5}\mathbf{\%} \\ \mathbf{=}\mathbf{18}\mathbf{.}\mathbf{64}\mathbf{\%} \end{gathered}$$