External Equity and Weighted Marginal Cost of Capital

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FINHELP

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I am having trouble figuring this problem. I have the answers, but need to work through the problem so I fully understand.

Bennett Company is planning to launch a major expansion program which will require $1 million. The firm wants to maintain its current capital structure: debt = 30%, preferred stock = 20%, and common equity = 50%. New bonds will have an after-tax cost of 4.74 percent. New $100 par preferred stock will have a 9 percent dividend yield and will be sold to net the firm $98/share. Common stock with a current market price of $50 can be sold to net the firm $40 per share. The firm currently pays a $2 dividend and plans to increase its dividend at the constant rate of 5 percent per year. The retained earnings available to the expansion program are estimated to be $200,000.

a) To maintain the current capital structure, how much of the capital budget should be financed by external equity?

$300,000



b) Determine the cost of each individual component?

Cost of debt = 4.74%, Cost of preferred stock = 9.2%, Cost of retained earnings = 9.2%,

Cost of common stock – 10.25%



c) Compute the weighted marginal cost of capital.

8.177%
 
FINHELP said:
I am having trouble figuring this problem. I have the answers, but need to work through the problem so I fully understand.

Bennett Company is planning to launch a major expansion program which will require $1 million. The firm wants to maintain its current capital structure: debt = 30%, preferred stock = 20%, and common equity = 50%. New bonds will have an after-tax cost of 4.74 percent. New $100 par preferred stock will have a 9 percent dividend yield and will be sold to net the firm $98/share. Common stock with a current market price of $50 can be sold to net the firm $40 per share. The firm currently pays a $2 dividend and plans to increase its dividend at the constant rate of 5 percent per year. The retained earnings available to the expansion program are estimated to be $200,000.

a) To maintain the current capital structure, how much of the capital budget should be financed by external equity?

$300,000



b) Determine the cost of each individual component?

Cost of debt = 4.74%, Cost of preferred stock = 9.2%, Cost of retained earnings = 9.2%,

Cost of common stock – 10.25%



c) Compute the weighted marginal cost of capital.

8.177%
Click to expand...

Can you define the terms involved (e.g. capital structure, capital budget,external equity, Cost of common stock, weighted marginal cost of capital, etc.)?

What equations do you know of "relating" those terms?
 
Compute after-tax cost of bonds
K[sub:3q8a3158]D[/sub:3q8a3158] = Y/(1-F) x (1-tax rate)

For preferred stock
K[sub:3q8a3158]P[/sub:3q8a3158] = D[sub:3q8a3158]P[/sub:3q8a3158]/(P[sub:3q8a3158]P[/sub:3q8a3158] – F)

Cost of new common stock
K[sub:3q8a3158]N[/sub:3q8a3158]=D[sub:3q8a3158]1[/sub:3q8a3158]/(P[sub:3q8a3158]0[/sub:3q8a3158] – F) + g
 
FINHELP said:
Compute after-tax cost of bonds
K[sub:26yz4kl6]D[/sub:26yz4kl6] = Y/(1-F) x (1-tax rate)

For preferred stock
K[sub:26yz4kl6]P[/sub:26yz4kl6] = D[sub:26yz4kl6]P[/sub:26yz4kl6]/(P[sub:26yz4kl6]P[/sub:26yz4kl6] – F)

Cost of new common stock
K[sub:26yz4kl6]N[/sub:26yz4kl6]=D[sub:26yz4kl6]1[/sub:26yz4kl6]/(P[sub:26yz4kl6]0[/sub:26yz4kl6] – F) + g
Click to expand...

What are Y, F, D[sub:26yz4kl6]P[/sub:26yz4kl6], P[sub:26yz4kl6]P[/sub:26yz4kl6],D[sub:26yz4kl6]1[/sub:26yz4kl6], P[sub:26yz4kl6]0[/sub:26yz4kl6] & g?

What are their "values"?

.
 
Capital structure – The sum of long-term debt, preferred stock, common stock, capital surplus and retained earnings

Capital budget – amt of projected expenditures on assets

Weighted marginal cost of capital – weighted average of the component costs: cost of debt, cost of preferred stock, cost of common stock and cost of retained earnings.
 
D[sub:2y9iuuio]P[/sub:2y9iuuio]=2
P[sub:2y9iuuio]P[/sub:2y9iuuio]=100
D[sub:2y9iuuio]1[/sub:2y9iuuio]=2
g=.05

How am I doing so far?
 
So if I plug in the numbers in the formula I will get each component cost. If you know the weight of each and we know the component costs from part b. We can multiply them to get the weighted cost of each then add them up for the total percentage. I don't think I am weighing them right because I was first thinking debt .30 with a component cost of 4.74%, preferred .20 with a component cost of 9.2%, and common .50 with a component cost of 10.25%. The weights add up to 1.00, but now this does not take into account the retained earnings at 9.2%.

I know this must seem so ridiculous that I can't figure this out.
 
I figured out part c and it came to the right answer.

Debt .30 4.74% 1.422%
Preferred Stock .20 9.2% 1.84%
Common Equity .30 10.25% 3.075%
Retained Earnings .20 9.2% 1.84%
Total 1.00 8.177%
 
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