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 7.2%. Also, bonds can be issued at a pretax cost of 6.4%. Common Stock: Retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $68. Flotation costs will be $3 per share. The recent common stock dividend was $3.54. Dividends are expected to grow at 7% in the future.

Required:
What is the cost of capital if the firm uses bank loans and retained earnings?

Question

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Respuesta :

Parrain Parrain · Answer 1 · 2021-05-06T03:12:14+02:00

Answer: 9.44%

Explanation:

Find the cost of equity using the Gordon Growth model:

Price of stock = Next dividend/ (Cost of equity - growth rate)

68 = (3.54 * 1.07) / (Cost of equity - 7%)

(Cost of equity - 7%) * 68 = 3.79

Cost of equity - 7% = 3.79 / 68

Cost of equity = 3.79 / 68 + 7%

= 12.57%

Cost of debt is the cost using bank loans of 7.2%

Cost of Capital:

= (Weight of debt * Cost of debt * (1 - tax)) + (Weight of equity * cost of equity)

= (40% * 7.2% * ( 1 - 34%)) + (60% * 12.57%)

= 9.44%