Question 3

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 30%

Preferred stock 5%

Common stock equity 65%

Debt:

The firm can sell a 20 year, RM1,000 par value, 9% bond for RM980. A flotation cost of 2% of the face value would be required in addition to the discount of RM20.

Preferred stock:

The firm has determined it can issue preferred stock at RM65 per share par value. The stock will pay an RM8.00 annual dividend. The cost of issuing and selling the stock is RM3 per share.

Common stock:

The firms common stock is currently selling for RM40 per share. The dividend expected to be paid at the end of the coming year is RM5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago the dividend was RM3.45. It is expected to sell , a new common stock issue must be underpriced at RM1 per share and the firm must pay RM1 per share in flotation costs. Additionally, the firms marginal tax rate is 40%.

Calculate the firms weighted average cost of capital assuming the firm has exhausted all retained earnings.