Topics: Finance, Stock, Weighted average cost of capital Pages: 5 (1240 words) Published: July 16, 2013
Ace Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter (OTC) market. During 2009, the Dallas-based company experienced sharp increases in both sales and earnings. Because of this recent growth, Kaka, the company`s treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30% long-term debt, 10% preferred stock, and 60% common stock equity for at least the next 3 years. The firm is in the 40% tax bracket. Ace`s division and product managers have presented several competing investment opportunities to Jen. However, because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule (IOS) is shown below. Investment Opportunities Schedule (IOS) for Star Products Company Investment OpportunityInternal rate of return (IRR)Initial investment C25%700,000


To estimate the firm`s weighted average cost of capital (WACC), Kaka contacted a leading investment banking firm, which provided the financing cost data shown in the following table.

Financing Cost Data Ace Products Company
Long-term debt: The firm can raise $450,000 of additional debt by selling 15-year, $1,000- par-value, 9% coupon interest rate bonds that pay annual interest. It expects to net $960 per bond after flotation costs. Any debt in excess of $450,000 will have a before-tax cost, rd, of 13%.

Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $70 par value and a 14% annual dividend rate and will net $65 per share after flotation costs.

Common stock equity: The firm expects dividends and earnings per share to be $0.96 and $3.20, respectively, in 2010 and to continue to grow at a constant rate of 11% per year. The firm`s stock currently sells for $12 per share. Expects to have $1,500,000 of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $9 per share after underpricing and floatation costs.

a. Calculate the cost of each source of financing, as specified: (1) Long- term debt, first $450,000.

The cost of debt is the after tax YTM. YTM is the discounting rate that will make the present value of interest and principal equal to the price today. We use the RATE function to calculate the YTM Maturity15years

Annual interest90The formula is
Price960Price = Annual interest X PVIFA (period, rate) + Par value X PVIF (period, rate) Par Value1000
After tax cost of debt5.71%After tax cost = Before tax cost X (1-tax rate)

(2) Long- term debt, greater than $450,000.

For debt greater than $450,000 the before tax cost would be 13% Before tax cost13%
After tax cost7.80%

(3) Preferred stock, all amounts.

Preferred stock is a perpetuity and the cost is given as Annual dividend/Price Annual dividend9.8
Price65Cost = Annual dividend/price
Cost of preferred stock15.08%

(4) Common stock equity, first $1,500,000.

Retained earning cost is the cost of internal...
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