Q1.
Coupon rate = 8% at par
Preferred stock = 25 USD/ share with 2.5 USD per dividend
Next years dividend= 1.5 USD per share
Growth rate= 5% per year
Marginal tax rate= 35%
5% preferred stock
45% debt
50% common stock
Solution
The first step will be to compute the after-tax cost of debt from the company’s marginal tax rate.
The next step is to compute the cost of each type of finance from the provided information
For the preferred stock
For the common stock with a 5% growth rate,
cost of capital, k=WACC
A firm’s weighted cost of capital computes the overall cost of capital of the firm from proportionately weighted categories of the firm’s capital sources.
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The table below shows the WACC based on the weights of each source of capital
| source | cost | weight | weight*cost |
| Preferred stock | 10 | 5% |
=10*0.05 =0.5 |
| Common stock | 12.5 | 50% |
=12.5*0.5 =6.25 |
| debt | 5.2 | 45% |
=5.2*0.45 =2.34 |
The required WACC is the sum of the cost of capital for all the sources of finance
=2.34+6.25+0.5
=9.09%
Q2.
30% debt
65% common stock
5% preferred Stock
The sources of capital and weights can be represented as shown in the table below
| source | cost | weight | weight*cost |
| Preferred stock | 10 | 5% |
=10 * 0.05 =0.5 |
| Common stock | 12.5 | 65% |
=12.5 * 0.65 =8.125 |
| debt | 5.2 | 30% |
=5.2*0.3 =0.702 |
The WACC will be
0.702%+8.125%+0.5%
=9.327%
Bad Boys Inc. Will have a future discount rate of 9.09% when it uses the first proportion of the capital sources and a 9.327% when using the second proportion.
