A company can issue new 20-year bonds at par that pay 5 percent annual coupons. The net proceeds to the firm (after taxes) will be 98 percent of par value. They estimate that new preferred shares providing a $2 annual dividend could be issued to investors at $25 per share to “net” the firm $22 per share issued (after taxes). The company has a beta of 1.10, and present market conditions are such that the risk-free rate is 1 percent, while the expected return on the market index is 10 percent. The firm’s common shares trade for $30, and they estimate the net proceeds from a new common share issue would be $28.50 per share (after tax considerations). The firm’s tax rate is 20 percent.
a. Determine the firm’s cost of long-term debt, preferred shares, and common equity financing (internal and external sources) under the conditions above.
b. What is the firm’s weighted average cost of capital, assuming that it has a “target” capital structure consisting of 30 percent debt, 10 percent preferred equity, and 60 percent common equity? Assume that it has $3 million in internal funds available for reinvestment and requires $3 million in total financing.
c. Suppose everything remains as above, except that the company decides it needs $5 million in total financing. Calculate the firm’s marginal cost of capital.