The stock of IMB Computing sells for $52, and last year's dividend was $2.10. A flotation cost of 10% would be required to issue new common stock.
IMB's preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share (inclusive of flotation costs).
Security analysts are projecting that the common dividend will grow at a rate of 7% a year.
The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 35%.
The market risk premium is 6%, the risk-free rate is 6.5%, and IMB's beta is 0.83. In its cost-of-capital calculations, IMB is funded with $16,000,000 of long-term debt, $25,000,000 of common equity, and $3,000,000 of preferred stock.
Part 1: Component Costs
a) Calculate the after-tax cost of debt.
b) Calculate the cost of preferred stock
c) Calculate the cost of common equity from retained earnings. Use both the CAPM method and the dividend growth approach.
d) Calculate the cost of new common equity. Use both the CAPM method and the dividend growth approach.
For the CAPM approach, find the difference between difference between re and rs as determined by the dividend growth approach and add that differential to the CAPM value for rs.
Part 2: Capital Structure
e) Calculate the capital structure weights.
f) Calculate the weighted average cost of capital assuming internal equity and calculate the weighted average cost of capital assuming new external equity. Perform the calculations for both the dividend growth and CAPM method.
Part 3: Project Cost of Capital
g) Suppose IMB is evaluating three projects. Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred stock, and common equity.
The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from reinvested earnings.
a. (1) equity invested in Project A would have a beta of 0.5 and an expected return of 9%.
b. (2) equity invested in Project A would have a beta of 1.0 and an expected return of 10%.
c. (3) equity invested in Project A would have a beta of 2.0 and an expected return of 11%.
Calculate the weighted average cost of capital for each project. In your report, identify which project should be accepted and which should be rejected.