Global Internet company is looking to expand their operations. They are evaluating their cost of capital based on various financing options. Investment bankers informed them that they can issue new debt in the form of bonds at a cost of 8%, and issue new preferred stocks for the price of $25 per share paying $2.5 dividends per share. Their common stock is currently selling for $20 per share and will pay a dividend of $1.5 per share next year. They expect a growth rate in dividends of 5% per year, and their marginal tax rate is 35%.a)      If Global raises capital using 45% debt, 5% preferred stock, and 50% common stock what is their cost of capital? b)      If Global raises capital using 30% debt, 5% preferred stock, and 65% common stock what is their cost of capital?c)    Evaluate the two finance options and identify which one they should choose? Assess the advantages and disadvantages of your choice?

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Asked Nov 17, 2019
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Global Internet company is looking to expand their operations. They are evaluating their cost of capital based on various financing options. Investment bankers informed them that they can issue new debt in the form of bonds at a cost of 8%, and issue new preferred stocks for the price of $25 per share paying $2.5 dividends per share. Their common stock is currently selling for $20 per share and will pay a dividend of $1.5 per share next year. They expect a growth rate in dividends of 5% per year, and their marginal tax rate is 35%.

a)      If Global raises capital using 45% debt, 5% preferred stock, and 50% common stock what is their cost of capital? 

b)      If Global raises capital using 30% debt, 5% preferred stock, and 65% common stock what is their cost of capital?

c)    Evaluate the two finance options and identify which one they should choose? Assess the advantages and disadvantages of your choice?

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Expert Answer

Step 1

Part a & b:

Calculation of Cost of Capital:

a. The cost of capital is 9.09%.

b. The cost of capital is 10.19%.

Excel Spreadsheet:

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A В C D 1 Part a Return Total Return Weight 2 3 Debt 5.20% 45% 2.34% 4 Common Stock 5 Preferred Stock 12.50% 50% 6.25% 0.50% 5% 10.00% Cost of Capital 6 9.09% 7 8 Part b Return Total Return 5.20% 9 Weight 10 Debt 30% 1.56% 11 Common Stock 65% 12.50% 8.13% 5% Cost of Capital 12 Preferred Stock 10.00% 0.50% 13 10.19%

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Step 2

Excel Workings:

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A В C D 1 Part a Weight 0.45 4 Common Stock 0.5 5 Preferred Stock 0.05 Total Return 2 Return - 8%*(1-35%)|B3*C3 -(1.5/20)+5% -B4*C4 3 Debt =2.5/25 -B5 C5 6 Cost of Capital =D3+D4+D5 7 Partb Weight 0.3 11 Common Stock 0.65 12 Preferred Stock 0.05 Cost of Capital Return Total Return =8%*(1-35%)| =B10*C10 (1.5/20)+5% -B11*C11 =2.5/25 10 Debt -B12*C12 =D10+D11+D12 13

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