[Anonymous]

NINJA Question –

I am not understanding how this question is getting $200,000 for the equity (or common stock) portion of the calculation. I am not seeing that number any where.

Q: 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% Correct Answer

C) 6.8% My answer

D) 7.3%

Explanation Given: 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%. ***

I do not see where the 200,000 amount is coming from unless they are just taking the RE amount the company has and dividing it by the 50% weight given for equity. But then I would think it should have a note in there that the company must use ALL R/E for capital in given year.

Thanks in advance for any help!

[jsch8912]

Hey @Dgilbreath: I got this question wrong too. But I got 6.9% which is not even an option.

Debt: 4.8% x 30% = 1.44%

Preferred Stock: 105 x 8% = 8.4 / (105 – 5) = 8.4% x 20% = 1.68%

Common stock = 7 / (100 – 3 – 5) = 7.6% x 50% = 3.8%

I don't get why you would just use the 7% for common stock though. Anyone?

[jsch8912]

Q394

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 cost of funds from retained earnings for Williams, Inc., is:

A.

7.0%.

Incorrect B.

7.6%.

C.

7.4%.

D.

7.8%.

For this question, the answer is A.

The cost of retained earnings is 7.0%.

The cost of retained earnings, using the Gordon Model, ignores flotation costs and underpricing, since the firm does not need to issue new stock. However, it must earn a return for the owners of the retained earnings, that is, the existing shareholders, as follows:

krm = (D1 / PO) + g, or krm = 7 / 100 + 0% = 7.0%

[jsch8912]

Q393

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 cost of funds from the sale of common stock for Williams, Inc., is:

A.

7.0%.

Correct B.

7.6%.

C.

7.4%.

D.

7.8%.

For this question, the answer is B.

The cost of funds from the sale of common stock is 7.6%.

The cost to the firm of selling new common stock can be determined using the Gordon Model (dividend capitalization model). This formula states:

kcm = (D1 / (PO – u – f)) + g

= (7 / (100 – 3 – 5)) + 0

= 7 / 92

= 7.6%

[Author]

Replies