Question

The target capital structure is 45% debt, 5% preferred, and 50% equity. If the before tax cost of debt is 8%, the tax rate is 30%, the cost of preferred is 9%, the cost of retained earnings (existing common) is 12%, and the cost of issuing new common equity is 13%. What is the cost of capital if new common equity shares are issued? Group of answer choices 10.55% 8.97% 10.05% 9.47%

Answer 1

The cost of capital if new common equity shares are issued is 15.47%.

Step-by-step explanation:

To calculate the cost of capital when new common equity shares are issued, we need to calculate the cost of each component of the capital structure and then combine them using the weights of each component.

The cost of debt is 8% and since interest expense reduces the tax liability, the after-tax cost of debt is 8% * (1 - 30%) = 5.6%.

The cost of preferred stock is 9% and the cost of equity (retained earnings) is 12%. The cost of issuing new common equity is 13%.

Using the weights of each component in the capital structure, we can calculate the cost of capital as follows:

Cost of debt: 45% * 5.6% = 2.52%

Cost of preferred stock: 5% * 9% = 0.45%

Cost of equity (retained earnings): 50% * 12% = 6%

Cost of issuing new common equity: 50% * 13% = 6.5%

Total cost of capital = 2.52% + 0.45% + 6% + 6.5% = 15.47%

Therefore, the cost of capital if new common equity shares are issued is 15.47%.