The company has a target capital structure of 40 percent debt and 60 percent equity. Bonds pay 10 percent coupon (semi-annual payout), mature in 20 years, and sell for $849.54. The company stock beta is 1.2. Risk-free rate is 10 percent, and market risk premium is 5 percent. The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The company’s marginal tax rate is 40 percent. If flotation cost for new equity is 10 percent, the cost of new equity capital will be: A) 16.9%. B) 13.6%. C) 16.6%. D) 16.0%.

answer D 2 ways 10 + 1.2 * 5 = 16 2 * 1.08 / (.16-.08) = 27 ==> cost of share So 16% is cost of equity all other things like cost of debt are distractors

A?

This is a multipart question . I have copied only the last question which starts with the last line of this question If flotation cost for new equity is 10 percent, the cost of new equity capital will be ???

delhirocks can you please explain this ??How did you calculate ??

cpk, wouldn’t you include floatation cost? They are asking for cost of new equity. Iam not sure how that would figure in as that would be a one time cost (10%*(1-0.4)=6%) Thats how I came to A.

10% is the risk free rate. and since flotation cost is a one time cost, (we all agree) – it should make its way into the calculation of ke (cost of equity) but should be factored after. Probably this might be closer to the answer Cost of debt = 12% from the bond @ 40% weight * (1-.4) = 2.88% Cost of Equity = 16% @ 60% weight = 9.6% So cost of new equity = 9.6 /.9 + 2.88 = 13.54% so choice C – 13.6%

N=40 PV = -849.54 PMT = 50 FV = 1000 I/Y = 5.9999 BEY = 2*I/Y = 5.9999*2 = 11.9998 Cost of debt = 11.9998 E® = RFR + Beta*(Market Prem) E® = 0.10 + 1.2*(0.05) = 0.16 WACC = (0.40)*(0.119998)*(1 - 0.40) + (0.60) (0.16) 0.02879952+0.096 WACC = 0.12479952 = 12.48% - Dinesh S EDIT: ooops, I misread the question again…

but isn’t that the WA cost of capital, they are asking for cost of EQUITY capital. Why should debt be featured here. Also, if we are including the cost of floatation, shouldn’t that be the after tax cost of floatation i.e 10% * (1-40%) = 6% and the cost of “new”_“equity” capital should be 16% * 1.06 = 16.96%…

Where have they dealt with Flotation costs, if ever I need to check up in the CFAI book. Not there in either of Stalla or Schweser, if it’s there, its in mighty fine print, and my spectacled eyes have missed them. CP

it’s from schweser …delhirocks your ans is correct …Q ID 38915

dinesh/cpk…the moment I read this question…I also yanked out my 12 c and cranked out the cost of debt…only later did I realize that is not required. I am doing that more often than I would like to…kills my average (time)

CP, Flotation costs are covered in an optional segment in the CFAI book (V4 pg 109-111). Because it’s in optional reading, I don’t think we’ll see this on the exam…

delhirocks Wrote: ------------------------------------------------------- > but isn’t that the WA cost of capital, they are > asking for cost of EQUITY capital. Why should debt > be featured here. > > Also, if we are including the cost of floatation, > shouldn’t that be the after tax cost of floatation > i.e 10% * (1-40%) = 6% > > and the cost of “new”_“equity” capital should be > > 16% * 1.06 = 16.96%… Do not remeber read this in CFAI book either. So floatation cost is tax deductible?

shouldn’t they be. its a cost for the company. The only thing that isn’t tax deductible is the dividend because they are dispersion of profits. I don’t remember reading this, but am pretty sure they should be tax deductible