Finance 6 Essay Example | Topics and Well Written Essays - 3000 words

Finance 6 - Essay Example Thus from the given data, Kd = (8.5%) (1-0.30) = 5.95% b. The cost of preferred stock is calculated by the following formula: Kp = Dp / [Pp (1-F)] Where, Kp = cost of preferred stock Dp = preferred dividend Pp= preferred stock price F= floatation cost (Brigham & Daves, 2009, p.330). From the data, Kp = 9/91 = 9.89% c. Cost of common stock (at constant growing rate) can be calculated by the following formula: Ks = (D1/P0) + g Where, Ks = cost of common stock D1 = Dividend at the end of the first year P0 = price of the stock at the beginning of the first year g = growth rate (Gitman, 2007, p.448). From the data, Ks = (0.75/15) + 0.06 = 11% d. Calculation of Weighted Average Cost of Capital (WACC): Capital Component Percentage of capital structure Cost Product (PercentageÃâ€"Cost) Debt 0.35 5.95% 2.08% Preferred Stock 0.05 9.89% 0.49% Common Stock 0.60 11% 6.60% WACC 9.17% Page 1 No. 2 Solution: Cost of retained earnings (Kre) = Ke (1-f) Where, Kre = cost of retained earnings Ke = cost of equity f = floatation cost (Kapil, 2011, p.278). Ke = (2.10/34) + 0.06 = 12% From the given data, Kre = 0.12 (1-2.38) = (16.56%) (negative) Cost of new common stock (Kn) = (D1/Nn) + g Where, Kn = cost of new issues of common stock D1 = Dividend at the end of first year Nn = net proceeds from the sale of new common stocks g = constant growth rate (Gitman, 2007, p.448) From the given data, Kn = (2.10/34) + 0.06 = 12.18% ... The original balance sheet reflects 10 percent debt and 90 percent equity. It may here be observed that companies in general tend to lessen their amounts of debts and increase equity amounts or make investments. In the long run in the business operations of any company, the concept of remaining free of debt may not pay well for the business profits. Instead it may be preferable to base a company’s capital structure on the cost of capital for the company. Thus, borrowing money for a long term and reinvesting the amounts in business projects is expected to generate profits for the company. Hence, an optimal structure may reflect on 30-40 percent of debt and the rest in equity for the firm (Kennon, 2011). c. A company may alter its capital structure and buy certain amounts of equity in exchange for new debt thus substituting debt for equity. This would not have any effect on the cost of capital of the company since the overall cost of capital employed does not change. The transac tion remains neutral both for the company as well as the investor (Vernimmen & Quiry, 2009, p.448). d. If a company uses too much of debt financing, then the financial condition of the company may be in a difficult situation. This is primarily because in the long run, the company may lose its value and that tends to increase the cost of capital of the firm. An optimal capital structure of a firm largely depends on the business risk of the firm; greater the risk higher is the possibility for the company to obtain its optimal capital structure (Drake & Fabozzi, 2010, p.178). Page 3 No.1 Solution: Assuming the cost of capital to be 10% and 12% the NPVs can be calculated on the costs and cash flows as given in the data. At 10%, NPV = $ 1102.98 At