[Anonymous]

I’m confused about the c/s part of the provided answer. The provided answer states that 50% of the total new funds must come from equity which would mean 200,000 of the new funds comes from equity. How was the 200,000 calculated? Thanks for your help.

ANSWER:

The weighted cost of capital is 6.6%.

Step 1: Calculate the after-tax cost of each source of capital.

The cost of long-term debt, after tax, is given at 4.8%.

The cost of new preferred stock can be calculated as:

kpm = D / (PO – u – f), or kpm = 8.40 / (105 – 0 – 5) = 8.4%

Where:

D = Annual dividend, or 0.08 × $105 (the par value), or $8.4

PO = Selling price to the public of the new issue

u = Underpricing

f = Flotation cost per share

New equity consists of retained earnings and/or new issues of common stock. In this case, 50% of the 200,000 of total new funds must come from equity. Since the firm has $100,000 in retained earnings, the relevant cost of new equity is the cost of retained earnings, 7 ÷ 100 + 0%, or 7.0%.

Step 2: Calculate the Weighted Average Cost of Capital:

Source After-Tax Cost x Weight =

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a. L-T Debt .048 x .30 = .0144

b. Pref. Stock .084 x .20 = .0168

c. Ret. Earnings .070 x .50 = .0350

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Weighted Average Cost of Capital = .066 or 6.6%