Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.
Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
Williams' preferred capital structure is long-term debt, 30%; preferred stock, 20%; and common stock, 50%.
The firm's weighted average cost of capital would be:
A.4.8%.
B.6.6%.
C.6.8%.
D.7.3%.
The answer is B. 6.6%. This is because Cost of Debt is 1.44%, Cost of preferred stock is 1.68% and cost of common stock is 3.5% (7/100 = 7% x 50% = 3.5%). Can anyone explain why when calculating the cost of capital for the issuance of common stock why in this answer we don't consider the underpricing and Flotation cost? Surely the underpricing and flotation cost will affect the amount of capital that can be raised?
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