Question

Southern Corporation has a capital structure of 40% debt and 60% common equity. This capital structure is expected not to change. The firm's tax rate is 34%. The firm can issue the following securities to finance capital investments:

Debt: Capital can be raised through bank loans at a pretax cost of 8.5%. Also, bonds can be issued at a pretax cost of 10%.
Common Stock: Retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $59. Flotation costs will be $3 per share. The recent common stock dividend was $3.15. Dividends are expected to grow at 7% in the future.
What is the cost of capital if the firm uses bank loans and retained earnings?
a. 9.9%
b. 10.3%
c. 12.6%
d. 11.8%
e. 10.4%

Answer 1

so cost of capital = 9.9 %

correct option is a 9.9%

Step-by-step explanation:

given data

capital structure = 40%

common equity = 60%

tax rate = 34%

pretax cost = 8.5%

pretax cost = 10%

market price = $59

Flotation costs = $3 per share

common stock dividend = $3.15

Dividends expected to grow = 7%

to find out

cost of capital if the firm uses bank loans and retained earnings

solution

cost of retained earning =
`(dividend* ( 1+growth rate ))/(stock price)` + growth rate ........................1

cost of retained earning =
`(3.15 * ( 1+0.07))/(59)` + 0.07

cost of retained earning =0.1271271186

and

cost of capital will be

cost of capital = weight for debit × ( cost of debit × ( 1 - tax rate ) ) + weight for common stock × cost of common stock

cost of capital = 0.40 × ( 8.5% × ( 1 - 0.34 ) ) + 0.60 × 0.1271271186

cost of capital = 0.0987

so cost of capital = 9.9 %

correct option is a 9.9%