CMA Study Group

  • 1.  New Part 2 - Ask for explanation

    Posted 10-24-2010 07:05 AM
    Hi, the correct answer is 6.9%. Can you please explain it to me how you get this? Thank you!
    I am having the new part 2 exam in 4 days.
    Williams Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.
    • Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.
    • Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
    • Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.
    • Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
    • Williams preferred capital structure is




    If Williams Inc. needs a total of $1,000,000, the firm's weighted average cost of capital would be


  • 2.  Re: New Part 2 - Ask for explanation

    Posted 10-25-2010 05:29 AM

    6.9 percent : The correct answer is: 6.9 percent.

    The weighted average cost of capital (rounded to one decimal place) is 6.9%. The formula to calculate the weighted average cost of capital is as follows:

    Ka = p1k1 + p2k2 + …pnkn

    Where:

    ka = cost of capital (expressed as a percentage)
    p = proportion that element comprises of the total capital structure
    k = cost of an element in the capital structure
    n = different types of financing (each with its own cost and proportion in the capital structure)

    The weighted average cost of capital (Ka) is the weighted average costs of debt, preferred stock, retained earnings, and common stock sales.

    The cost of debt is 4.8% and its weight is 0.3 (30%).
    The cost of preferred stock is the preferred stock dividend divided by its net price (price less flotation costs) which is 0.08($105)/($105-$5) = $8.4/$100 = .084 (or 8.4%).
    The weight for preferred stock is 0.2(20%).

    The cost of retained earnings is the cost of internal equity.
    The cost of common stock is the cost of external equity.

    Using the constant dividend growth model (Gordon’s model), the cost of retained earnings (Ke) is calculated by taking the next dividend payment and dividing it by the net price plus the constant dividend growth rate. There is no dividend growth rate for Williams.

    For Williams , Kee = $7 / ($100-$3-$5) = $7 / $92 = .076 (or 7.6%).

    Therefore, Ka = 0.3(0.048) + 0.2(0.084) + 0.1(0.07) + 0.4(0.076) = 0.0144 + 0.0168 + 0.007 + 0.0304 = 0.0686 (or 6.9% rounded).



  • 3.  Re: New Part 2 - Ask for explanation

    Posted 10-25-2010 05:56 AM

    Ashraf, thank you. I think earlier I did not get how to calculate the retained earnings. But now your explanation makes a lot of sense to me.

    One more to add is that " The cost of retained earnings to the firm is essentially the same as the cost of new equity but without the adjustment for flotation costs"

     



  • 4.  Re: New Part 2 - Ask for explanation

    Posted 10-25-2010 07:20 AM

    Some tricks you may find, the main thing to Know how to calculate the cost of debt and the tax effect on it, and use (constant dividend growth model (Gordon’s model) ) to calculate the cost of equity and the cost of retained earnings after needed adjustment for the later ( no next divident to be calculated )

    I wish you good luck with your next exam