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A firm has determined its optimal capital structure which is...

A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions.

Source of Capital Target Market Proportions

Long Term Debt 25%
Preferred Stock 20%
Common Stock 55%

Debt: The firm can sell a 10-year, RM1,000 par value, 6.50 percent bond for RM960. A flotation cost of 2 percent of the face value would
be required in addition to the discount of RM40.

Preferred Stock: The firm has determined it can issue preferred stock at RM71.25 per share par value. The stock will pay a RM10.50
annual dividend. The cost of issuing and selling the stock is RM3.15 per share.

Common Stock: A firm's common stock is currently selling for RM17.15 per share. The dividend expected to be paid at the end of the
coming year is RM1.65. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was
RM1.45. It is expected that to sell, a new common stock issue must be underpriced RM1 per share in floatation costs.

Additionally, the firm's marginal tax rate is 35 percent.

Calculate
(a) The firm's before-tax and after-tax cost of debt.
(b) The firm's cost of preferred stock.
(c) The firm's cost of a new issue of common stock
(d) The firm's cost of retained earnings
(e) The weighted average cost of capital up to the point when retained earnings are exhausted.
(f) If the target market proportion of long-term debt is reduced to 20 percent - increasing the proportion of common stock equity to 65
percent, explain the impact to preferred stock component and the revised weighted average cost of capital.

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a). Before-tax cost of debt= 6.91%; After-tax cost of debt=4.49%

b). Cost of preferred stock=15.42%
c). Cost of a new issue of common stock=13.45%
d). Cost of retained earnings=13.05%
e). Weighted average cost of capital=11.60%

Step-by-step explanation

(a). The firm's before-tax and after-tax cost of debt

Before-tax cost of debt= {I + [(PVD -MVD-Fc)/n]}/ [(PVD +MVD-Fc)/2] x 100%
Where:
I-Interest in amounts=1,000 x 6.5%=65

PVD-Per value of the Bond=1,000

MVD-Market of the Bond=960

n-Maturity period=10 years

Fc- Flotation cost=2% x 1,000=20

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6/29/22, 8:05 AM [Solved] A firm has determined its optimal capital structure which is... | Course Hero

Before-tax cost of debt= {65+ [(1,000 -960-20)/10]}/ [(1,000 +960-20))/2] x 100%

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Before-tax cost of debt= {(65+2)/970 x100% 숿
Before-tax cost of debt= 6.91%
After-tax costAnswer
Question of debt=Before-tax
& Explanationcost of debt x (1-tax
Related rate)
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After-tax cost of debt=6.91% x (1-0.35)
After-tax cost of debt=6.91% x 0.65
After-tax cost of debt=4.49%
(b) The firm's cost of preferred stock
Cost of preferred stock=Pdiv/(Po-Fc) x 100%
Where:
Pdiv-Preference dividends=10.50

Po-Per value=71.25

Fc- Flotation cost=3.15

Cost of preferred stock=[10.50/(71.25-3.15)] x 100%

Cost of preferred stock=10.50/68.10 x 100%
Cost of preferred stock=15.42%
(c) The firm's cost of a new issue of common stock
Cost of a new issue of common stock=D1/[(Po-Fc) +g] x100%
Where:
D1-Expected dividends=1.65

Po-Current market value=17.15

Fc- Flotation cost=1

g-Growth rate=(1.65-1.45)/1.45 x 100%= 13.79% (In 4 years); Growth per year=13.79%/4=3.45%

Cost of a new issue of common stock=1.65/[(17.15-1) +0.0345] x100%

Cost of a new issue of common stock=(1.65/16.15)+0.0345 x100%
Cost of a new issue of common stock=(0.10 +0.0345) x100%
Cost of a new issue of common stock=13.45%
(d) The firm's cost of retained earnings
Cost of retained earnings=D1/[(Po +g] x100%
Cost of retained earnings=[(1.65/17.15) +0.0345] x100%
Cost of retained earnings=[0.096 +0.0345] x100
Cost of retained earnings=13.05%
Retained earnings is a source of internal financing which does not require any flotation cost. Since the retained earnings are part of
equity, the formula used is the same as that of Equity except flotation costs
(e) The weighted average cost of capital
At the point when retained earnings are exhausted, the company will be financed by external financing. That is, Debt, Common stock
or Preferred stock
Weighted average cost of capital=WACC = WdKd + WeKe + WpKp
Where;
Wd-Proportion of Debt=25%
We-Proportion of common stock=55%
Wp-Proportion of preferred stock=20%
Kd -Cost of debt=4.49%
Ke -Cost of common stock=13.45%
Kp -Cost of preferred stock=15.42%
Weighted average cost of capital=(0.25 x 4.49%) +(0.55x 13.45%)+(0.20x 15.42%)
Weighted average cost of capital=1.12% +7.40% +3.08%
Weighted average cost of capital=11.60%
(f) If the target market proportion changes
If the target market proportion of long-term debt is reduced to 20 percent and the proportion of common stock equity increased to
65%, the preferred stock component will decrease by 5% to 15%.
Wd-Proportion of Debt=20%
We-Proportion of common stock=65%
Wp-Proportion of preferred stock=15%
Weighted average cost of capital=(0.20 x 4.49%) +(0.65x 13.45%)+(0.15x 15.42%)
Weighted average cost of capital=0.898% +8.74% + 2.31%
Weighted average cost of capital=11.95%

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6/29/22, 8:05 AM [Solved] A firm has determined its optimal capital structure which is... | Course Hero

The interest on the debt is tax-deductible, making the use of debt much cheaper thus; the use of less debt in the capital structure
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will increase the WACC as the company will now be financed by more expensive source financing. The higher the WACC, the lower
the value of the company will be.
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