Cost of Capital

1. The Dempere Imports Company’s EPS in 2009 was $2.82, and in 2004 it was $1.65. The company’s payout ratio is 30%, and the stock is currently valued at $41.50. Flotation costs for new equity will be 15%. Net income in 2010 is expected to be $15 million. The market-value weights of the firm’s debt and equity are 40% and 60%, respectively.

a. Based on the five-year track record, what is Dempere’s EPS growth rate? What will the dividend be in 2010?

b. Calculate the firm’s cost of retained earnings and the cost of new common equity.

c. Calculate the break-point associated with retained earnings.

d. If Dempere’s after-tax cost of debt is 8%, what is the WACC only with debt and retained earnings? With debt and new common equity?

2. TRM Consulting Services currently has the following capital structure:

Source
Book Value
Quantity
Common Stock
$6,500,000
350,000
Preferred Stock
$375,000
7,500
Debt
$4,000,000
4,000

Debt is represented by 15-year original maturity bonds, issued five years ago, with a coupon rate of 8% and are currently selling for $965. The bonds pay interest semiannually. The preferred stock pays a $5 dividend annually and is currently valued at $60 per share. Flotation costs on debt and preferred equity are negligible and can be ignored, but they will be 8% of the selling price for common stock. The common stock, which can be bought for $32.00, has experienced a 5% annual growth rate in dividends and is expected to pay a $1.50 dividend next year. In addition, the firm expects to have $150,000 of retained earnings. Assume that TRM’s marginal tax rate is 35%.

a. Set up a worksheet with all of the data from the problem in a well organized input area.

b. Calculate the book-value weights for each source of capital.

c. Calculate the market-value weights for each source of capital.

d. Calculate the component costs of capital (i.e., debt, preferred equity, retained earnings, and new common equity).

e. Calculate the weighted average costs of capital using both the market value and book-value weights.

3. Suppose that TRM Consulting Services has discussed its need for capital with its investment bankers. The bankers have estimated that TRM can raise new funds in the capital markets under the following conditions:

Source
Range
After-tax Cost
Retained Earnings
Up to 150,000
9.69%
Common Equity
Up to 1,000,000
10.10%

1,000,001 to 3,000,000
10.75%

More than 3,000,000
11.25%
Preferred Equity
Up to 200,000
8.33%

More than 200,000
8.75%
Debt
Up to 1,000,000
5.54%

1,000,001 to 2,000,000
6.00%

More than 2,000,000
6.50%

a. Using the information developed in the previous problem, calculate each of the break-points. Don’t forget to include the break-point due to retained earnings.

b. Create a chart of TRM’s marginal WACC curve using the market value weights. Make sure that it is a perfect step function.