Coco Company is financed entirely by common stock which is priced to offer a 10% rate of return.Coco has an income tax rate of 40%.If the company repurchases 40% of the stock and substitutes an equal value of debt costing 7%, what is the cost on the common stock after repurchasing?
A)10%
B)11.2%
C)12%
D)None of the above

Question

Quizplus · Accepted Answer

Before repurchasing, the cost of common stock was 10%.
After repurchasing 40% of the stock, the cost of common stock will increase due to the financial risk. 
Let's assume that the new cost of common stock is x%. 
The value of the firm (V) will remain the same after repurchasing stock, which means:

V = E + D

where E is the value of equity and D is the value of debt.

Since the repurchase is done at an equal value, we can assume that the value of equity has decreased by 40%. Hence:

V = 0.6E + D

The cost of debt is 7%. Using the weighted average cost of capital formula, we get:

10% = x(0.6) + 0.4(7%)

Solving for x, we get:

x = 11.2%

Therefore, the cost of common stock after repurchasing is 11.2% (option B).

Coco Company Is Financed Entirely by Common Stock Which Is