Homework Directions: Answer The Following Questions In A Set

Homework Setdirections Answer The Following Questions In A Separate D

Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Bad Boys, Inc. is currently selling for $20.00 a share. Bad Boys, Inc. expects to pay a dividend of $1.50 per share next year. An equity analyst foresees a growth in dividends at a rate of 5% per year. The Bad Boys, Inc. marginal tax rate is 35%. If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Bad Boys, Inc.’s cost of capital? If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys, Inc.’s cost of capital?

Paper For Above instruction

Evaluating a firm's weighted average cost of capital (WACC) involves calculating the cost components of debt, preferred stock, and equity, then combining these based on the firm's capital structure. For Bad Boys, Inc., the analysis requires understanding the cost of each component and applying the appropriate tax adjustments and weights in the capital structure.

Cost of Debt

The company plans to issue new debt at par with a coupon rate of 8%. Since interest payments on debt are tax-deductible, the after-tax cost of debt (Kd) is calculated as:

Kd = Coupon Rate × (1 - Tax Rate) = 8% × (1 - 0.35) = 8% × 0.65 = 5.2%

Cost of Preferred Stock

The preferred stock dividend is $2.50 per share, issued at a price of $25. The cost of preferred stock (Kp) is the dividend yield:

Kp = Dividend / Price = $2.50 / $25 = 10%

Cost of Common Equity

Using the dividend growth model (Gordon Growth Model), the cost of common equity (Ke) is calculated as:

Ke = (D1 / P0) + g

Where:

  • D1 = $1.50
  • P0 = $20.00
  • g = 5%

Thus:

Ke = ($1.50 / $20) + 0.05 = 0.075 + 0.05 = 12.5%

Calculations for Different Capital Structures

We now compute the WACC under two scenarios: one with 45% debt and another with 30% debt.

Scenario 1: 45% Debt, 5% Preferred, 50% Equity

  • Debt weight (wd) = 0.45
  • Preferred stock weight (wp) = 0.05
  • Equity weight (we) = 0.50

WACC is calculated as:

WACC = (wd × Kd) + (wp × Kp) + (we × Ke)

Plugging in the values:

WACC = (0.45 × 5.2%) + (0.05 × 10%) + (0.50 × 12.5%) = 2.34% + 0.5% + 6.25% = 9.09%

Scenario 2: 30% Debt, 5% Preferred, 65% Equity

  • Debt weight (wd) = 0.30
  • Preferred stock weight (wp) = 0.05
  • Equity weight (we) = 0.65

WACC calculation:

WACC = (0.30 × 5.2%) + (0.05 × 10%) + (0.65 × 12.5%) = 1.56% + 0.5% + 8.125% = 10.185%

Conclusion

In summary, the weighted average cost of capital (WACC) for Bad Boys, Inc. is approximately 9.09% when the firm raises 45% of capital through debt and 10.19% when it raises 30% through debt, reflecting the varying capital structure. These calculations incorporate the cost of debt after tax, the dividend yield on preferred stock, and the expected return on equity. This analysis aids in financial decision-making regarding capital investment and valuation.

References

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  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Damodaran, A. (2019). Applied Corporate Finance. John Wiley & Sons.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261-297.
  • Copeland, T., Weston, J., & Shastri, K. (2021). Financial Theory and Corporate Policy. Routledge.
  • Investor.gov. (2023). Cost of Capital. U.S. Securities and Exchange Commission. https://www.investor.gov
  • Investopedia. (2023). Weighted Average Cost of Capital. https://www.investopedia.com
  • Gordon, M. J. (1959). Dividends, Earnings, and Stock Prices. The Review of Economics and Statistics, 41(2), 99-105.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.

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