[OntoBetterThings]

The question and answer key read:

Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.

Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.

Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

Williams’ preferred capital structure is long-term debt, 30%; preferred stock, 20%; and common stock, 50%.

The firm’s weighted average cost of capital would be:

A 4.8%.

B 6.6%.

C 6.8%.

D.7.3%.

The weighted cost of capital is 6.6%.

Step 1: Calculate the after-tax cost of each source of capital.

The cost of long-term debt, after tax, is given at 4.8%.

The cost of new preferred stock can be calculated as:

kpm = D / (PO – u – f), or kpm = 8.40 / (105 – 0 – 5) = 8.4%

Where:

D = Annual dividend, or 0.08 × $105 (the par value), or $8.4

PO = Selling price to the public of the new issue

u = Underpricing

f = Flotation cost per share

New equity consists of retained earnings and/or new issues of common stock. In this case, 50% of the 200,000 of total new funds must come from equity. Since the firm has $100,000 in retained earnings, the relevant cost of new equity is the cost of retained earnings, 7 ÷ 100 + 0%, or 7.0%.

Step 2: Calculate the Weighted Average Cost of Capital:

Source After-Tax Cost x Weight =

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a. L-T Debt .048 x .30 = .0144

b. Pref. Stock .084 x .20 = .0168

c. Ret. Earnings .070 x .50 = .0350

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Weighted Average Cost of Capital = .066 or 6.6%

Can someone please explain why cost of equity is 7/100 and not 7/(100-3-5)? My brain refuses to grasp the concept on this one question and knowing how these exams are structured, with my luck I will get 18 questions on this alone.

Thanks for your help

[OntoBetterThings]

In case anyone out there was having difficulty with this question as well, I got the answer to my own question.

I just had an epiphany and I figured it out!!! (Actually WTB told me on a different question). When computing cost of capital for retained earnings float and unenterprising are not used in the calculation (the money is already there).

[Author]

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