You are an investment manager at Securities Investment Plc., and you are advising the management of Microprocessors Limited, a manufacturer of microchips, on its capital structure. The following information is available to assist with your assessment. The firm: i. issued 10% preferred share which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. ii. has common share with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. Growth rate in dividends has been 5%. iii. can borrow funds by selling $1,000 par value at 10% coupon interest rate, 10-year debt. To sell securities, an average discount of $30 per bond is given. Assume that the tax rate is 35%. iv. has the following capital structure which it considers optimal. Type of Capital Book Value $ Long term debt 3 000 000 Preferred stock 500 000 Common stock 1200 000 Total $4 700 000 A. Determine the: i. Before- and after-tax cost of debt (4 marks) ii. Cost of preferred stock (2 marks) iii. Cost of common stock (2 marks) iv. Weighted Average Cost of Capital (4 marks) B. The firm has a beta of 1.4. The market return equals 12% and the risk-free rate of return is 7%. Determine the firm’s cost of common equity using the CAPM approach. (2 marks) C. Explain why cost of capital is measured on the after-tax basis. (2 marks) D. Why is using a weighted average cost of capital recommended rather than the cost of specific funds to determine a firm’s cost of capital?

Managerial Accounting: The Cornerstone of Business Decision-Making

7th Edition

ISBN:9781337115773

Author:Maryanne M. Mowen, Don R. Hansen, Dan L. Heitger

Publisher:Maryanne M. Mowen, Don R. Hansen, Dan L. Heitger

Chapter15: Financial Statement Analysis

Section: Chapter Questions

Problem 66P

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Question

You are an investment manager at Securities Investment Plc., and you are advising the management of Microprocessors Limited, a manufacturer of microchips, on its capital structure. The following information is available to assist with your assessment. The firm: i. issued 10% preferred share which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. ii. has common share with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. Growth rate in dividends has been 5%. iii. can borrow funds by selling $1,000 par value at 10% coupon interest rate, 10-year debt. To sell securities, an average discount of $30 per bond is given. Assume that the tax rate is 35%. iv. has the following capital structure which it considers optimal. Type of Capital Book Value $ Long term debt 3 000 000 Preferred stock 500 000 Common stock 1200 000 Total $4 700 000 A. Determine the: i. Before- and after-tax cost of debt (4 marks) ii. Cost of preferred stock (2 marks) iii. Cost of common stock (2 marks) iv. Weighted Average Cost of Capital (4 marks) B. The firm has a beta of 1.4. The market return equals 12% and the risk-free rate of return is 7%. Determine the firm’s cost of common equity using the CAPM approach. (2 marks) C. Explain why cost of capital is measured on the after-tax basis. (2 marks) D. Why is using a weighted average cost of capital recommended rather than the cost of specific funds to determine a firm’s cost of capital?

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