Question

Question:Masco Oil and Gas Company is a very large company with common stock listed on the New York Stock Exchange and bonds traded over the counter. As of the current balance sheet, it has three bond issues outstanding:

\(150 million of 10 percent series ....... 2026

\)50 million of 7 percent series ........... 2020

\(75 million of 5 percent series ........... 2016

The vice president of finance is planning to sell \)75 million of bonds next year to replace the debt due to expire in 2016. Present market yields on similar Baa-rated bonds are 12.1 percent. Masco also has \(90 million of 7.5 percent noncallable preferred stock outstanding, and it has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at \)80 per share, and its dividend per share is \(7.80.

The company has had very volatile earnings, but its dividends per share have had a very stable growth rate of 8 percent and this will continue. The expected dividend (D1) is \)1.90 per share, and the common stock is selling for \(40 per share. The company’s investment banker has quoted the following flotation costs to Masco: \)2.50 per share for preferred stock and $2.20 per share for common stock.

On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its equity at 50 percent. Masco sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. Masco’s corporate tax rate is 40 percent. Compute the cost of capital for the following:

a. Bond (debt) (Kd).

b. Preferred stock (Kp).

c. Common equity in the form of retained earnings (Ke).

d. New common stock (Kn).

e. Weighted average cost of capital.

Short answer

Answer

1. The cost of the bond is 7.26%
2. The cost of preferred stock is 10.06%
3. The cost of common stock is 12.75%
4. The cost of new common stock is 13.03%
5. The weighted average cost of capital is 10.005%

Step-by-step solution

Meaning of Cost of Capital

Cost of capital refers to a metric used to calculate the minimum return a business must earn to cover the cost incurred in the capital project.

Computation of cost of capital of bond (debt)

$$\begin{gathered} \mathit{C}\mathit{o}\mathit{s}\mathit{t}\mathit{o}\mathit{f}\mathit{d}\mathit{e}\mathit{b}\mathit{t}\mathbf{\left(}{\mathit{k}}_{\mathbf{d}}\mathbf{\right)}\mathbf{=}\mathit{Y}\mathit{i}\mathit{e}\mathit{l}\mathit{d}\mathbf{\times }\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{T}\mathbf{a}\mathbf{x}\mathbf{)} \\ \mathbf{=}\mathbf{12}\mathbf{.}\mathbf{1}\mathbf{\%}\mathbf{\times }\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{4}\mathbf{)} \\ \mathbf{=}\mathbf{7}\mathbf{.}\mathbf{26}\mathbf{\%} \end{gathered}$$

Computation of cost of preferred stock

$$\begin{gathered} \mathit{C}\mathit{o}\mathit{s}\mathit{t}\mathit{o}\mathit{f}\mathit{p}\mathit{r}\mathit{e}\mathit{f}\mathit{e}\mathit{r}\mathit{r}\mathit{e}\mathit{d}\mathit{s}\mathit{t}\mathit{o}\mathit{c}\mathit{k}\mathbf{\left(}{\mathit{k}}_{\mathbf{p}}\mathbf{\right)}\mathbf{=}\frac{\mathbf{D}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}\mathbf{P}\mathbf{r}\mathbf{e}\mathbf{f}\mathbf{e}\mathbf{r}\mathbf{r}\mathbf{e}\mathbf{d}\mathbf{S}\mathbf{t}\mathbf{o}\mathbf{c}\mathbf{k}}{\mathbf{P}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}\mathbf{-}\mathbf{F}\mathbf{l}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{s}\mathbf{t}} \\ \mathbf{=}\frac{\mathbf{7}\mathbf{.}\mathbf{80}}{(80-2.5)} \\ \mathbf{=}\mathbf{10}\mathbf{.}\mathbf{06}\mathbf{\%} \end{gathered}$$

Computation of cost of common equity

$$\begin{gathered} \mathit{C}\mathit{o}\mathit{s}\mathit{t}\mathit{o}\mathit{f}\mathit{c}\mathit{o}\mathit{m}\mathit{m}\mathit{o}\mathit{n}\mathit{s}\mathit{t}\mathit{o}\mathit{c}\mathit{k}\mathbf{\left(}{\mathit{k}}_{\mathbf{e}}\mathbf{\right)}\mathbf{=}\frac{\mathbf{D}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{m}\mathbf{o}\mathbf{n}\mathbf{S}\mathbf{t}\mathbf{o}\mathbf{c}\mathbf{k}}{\mathbf{P}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}}\mathbf{+}\mathit{G}\mathit{r}\mathit{o}\mathit{w}\mathit{t}\mathit{h}\mathit{R}\mathit{a}\mathit{t}\mathit{e} \\ \mathbf{=}\frac{\mathbf{1}\mathbf{.}\mathbf{90}}{\mathbf{40}}\mathbf{+}\mathbf{8}\mathbf{\%} \\ \mathbf{=}\mathbf{4}\mathbf{.}\mathbf{75}\mathbf{\%}\mathbf{+}\mathbf{8}\mathbf{\%} \\ \mathbf{=}\mathbf{12}\mathbf{.}\mathbf{75}\mathbf{\%} \end{gathered}$$

Computation of cost of new common equity

$$\begin{gathered} \mathit{C}\mathit{o}\mathit{s}\mathit{t}\mathit{o}\mathit{f}\mathit{n}\mathit{e}\mathit{w}\mathit{c}\mathit{o}\mathit{m}\mathit{m}\mathit{o}\mathit{n}\mathit{s}\mathit{t}\mathit{o}\mathit{c}\mathit{k}\mathbf{\left(}{\mathit{k}}_{\mathbf{n}}\mathbf{\right)}\mathbf{=}\frac{\mathbf{D}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{m}\mathbf{o}\mathbf{n}\mathbf{S}\mathbf{t}\mathbf{o}\mathbf{c}\mathbf{k}}{\mathbf{P}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}\mathbf{-}\mathbf{F}\mathbf{l}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{s}\mathbf{t}}\mathbf{+}\mathit{G}\mathit{r}\mathit{o}\mathit{w}\mathit{t}\mathit{h}\mathit{R}\mathit{a}\mathit{t}\mathit{e} \\ \mathbf{=}\frac{\mathbf{1}\mathbf{.}\mathbf{90}}{\mathbf{40}\mathbf{-}\mathbf{2}\mathbf{.}\mathbf{20}}\mathbf{+}\mathbf{8}\mathbf{\%} \\ \mathbf{=}\mathbf{5}\mathbf{.}\mathbf{03}\mathbf{\%}\mathbf{+}\mathbf{8}\mathbf{\%} \\ \mathbf{=}\mathbf{13}\mathbf{.}\mathbf{03}\mathbf{\%} \end{gathered}$$

Computation of weighted cost of capital

Particulars	Cost	Weights	Weighted cost
Debt	7.26%	50%	3.63%
Common stock	12.75%	50%	6.375%
Weighted average cost of capital (WACC)	10.005%