Longstreet Corporation has a target capital structure of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent.
The company has an optimal capital budget of $1,500,000. Longstreet will retain $500,000 of after-tax earnings this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, then the flotation costs are 10 percent for the first $500,000. If the company issues more than $500,000 in new equity the flotation cost increases to 15 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?
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A. B. C. D. E.C
First, calculate the after-tax component cost of debt as 7%(1 - 0.3) = 4.9%. Next, calculate the retained earnings breakpoint as $500,000/0.5 = $1,000,000. Thus, to finance its optimal capital budget, Longstreet must issue some new equity. Note, Longstreet needs $500,000 in financing beyond that which can be supported by retained earnings alone. However, of this additional $500,000, 50% will be new equity and the remaining 50% will represent preferred stock and debt. Thus,
Longstreet will issue $250,000 in new equity and flotation costs of 10% will be incurred. The cost of new equity is then[$5(1.10%)/$75(1 - 0.1)] + 10% = 8.15% +
10% = 18.15%. Finally, the WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.