Bryant Labs has asked its financial manager to measure the cost of each specific type of capital, as well as the weighted average cost of capital, using the following weights: 40% long-term debt; 10% preferred stock; and 50% common equity (consisting of retained earnings or common stock, or both). The firm's tax rate is 40%.
Debt: The firm can sell for $980 a 10-year, $1000 par bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond.
Preferred stock: Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.
Common stock: The firm's common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2011) is $4.00. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown on the following table:
Year Dividend
2010 $3.75
2009 3.50
2008 3.30
2007 3.15
2006 2.85
It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings.
a. Calculate the specific cost of each source of financing. If earnings available to common shareholders are expected to be $7 million, what is the break point associated with the exhaustion of retained earnings?
b. Determine the weighted average cost of capital between zero and the break point calculated in part b.
c. Determine the weighted average cost of capital just beyond the break point calculated in part b.