Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The cost of retained earnings is 14%, and the cost of new equity is 15.5%. Sadaplast expects to have a net income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%. Sadaplast has a dividend payout ratio of 25%. What is Sadaplast's cost of capital between the first and second break points?

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of common equity
Cost of retained earnings = 14%
Cost of new equity = 15.5%

We take a weighted average of the two as per the target capital structure of 65% common equity and 35% new equity:

Cost of common equity = (0.65 x 14%) + (0.35 x 15.5%) = 14.275%

Step 2: Calculate the cost of debt
Debt is being raised in two tranches:
Tranche 1: $25 million at an after-tax cost of 5.4%
Tranche 2: $20 million at an after-tax cost of 7.0%

The weighted average cost of debt can be calculated as follows:

Weighted average cost of debt = (25/45 x 5.4%) + (20/45 x 7.0%) = 6.06%

Step 3: Calculate the cost of preferred stock
The after-tax cost of preferred stock is estimated to be 11%.

Step 4: Calculate the overall cost of capital
We now have all the information we need to calculate the overall cost of capital between the first and second break points.

Weighted average cost of capital = (0.65 x 14.275%) + (0.30 x 6.06%) + (0.05 x 11%) = 11.75%

Therefore, the correct answer is C.

Sadaplast Has a Target Capital Structure of 65% Common Equity