The stock of Gao Computing sells for $50, and last year’s dividend was $2.10. A flotation cost of 10% would be required to issue new common stock. Security analysts are projecting that the common dividend will grow at a rate of 7% a year. Gao’s preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share. The firm can also issue additional long-term debt at an interest rate (or before-tax cost) of 10%, and its marginal tax rate is 35%. Gao uses a target capital structure with 50% debt, 5% preferred stock, and 45% common equity. The company expects to earn $17 million in after-tax income during the coming year, and it will retain 60 percent of those earnings.
a. What is the interest rate (cost) of retained earnings?
b. What is the interest rate (cost) of a new common stock issue?
c. What is the maximum capital budget that Gao can support with retained earnings?
d. Given a $25 million capital budget, what will be Gao’s marginal cost (interest rate) on common equity?
2. Assuming that GAO will not issue new equity and will continue to use the same target capital structure, what is the company’s WACC?
Please explain step by step.