Nova Corporation Is Interested In Measuring The Cost Of Each

Nova Corporation Is Interested In Measuring The Cost Of Each Specific

Nova Corporation is interested in measuring the cost of each specific type of capital as well as the weighted average cost of capital. The firm has raised capital from long-term debt, preferred stock, and common stock equity, with respective weights of 35%, 12%, and 53%. Its tax rate is 40%. The firm can issue debt by selling bonds with a $1,000 par value, a 6.5% coupon interest rate, a 10-year maturity, and an average discount of $20 per bond, along with a flotation cost of 2% of par value. Preferred stock can be issued at a $100 par value, with a 6% dividend rate, a sale price of $102 before costs, and a flotation cost of $4 per share. Common stock is traded at $35 per share, with next year's dividend expected to be $3.25, and dividends growing at 5% annually. Flotation costs are approximately $2 per share. Retained earnings of $100,000 are available for financing, after which new common stock will be issued.

Paper For Above instruction

The purpose of this analysis is to accurately determine each component of the firm's cost of capital, which is essential for making informed investment and financing decisions. Calculating the specific costs of debt, preferred stock, retained earnings, and new common stock provides a comprehensive view of the firm's overall capital costs. Additionally, understanding how different capital structures impact the weighted average cost of capital (WACC) helps in optimizing the firm's capital structure to minimize costs while maintaining financial flexibility.

Cost of Debt (After-Tax)

To compute the after-tax cost of debt, we start with the coupon rate of 6.5% on bonds with a $1,000 par value, implying an annual interest payment of $65. However, since bonds are issued at a discount, their effective cost must be adjusted to account for the discount and flotation costs. The bond's net proceeds are calculated by subtracting the discount and flotation costs from the par value.

Net proceeds of the bond issue = Par value - Discount - Flotation cost = $1,000 - $20 - (2% of $1,000) = $1,000 - $20 - $20 = $960.

Using the approximate yield to maturity (YTM) method, the pre-tax cost of debt (r_d) can be estimated as:

r_d ≈ [Coupon Payment + (Par Value - Net Proceeds) / Years] / [(Par Value + Net Proceeds)/2]

Plugging in the numbers:

r_d ≈ [$65 + ($1,000 - $960)/10] / [($1,000 + $960)/2] ≈ [$65 + $4]/$980 ≈ $69 / $980 ≈ 7.04%.

Adjusting for the tax rate of 40%, the after-tax cost of debt is:

Cost of debt (after-tax) = r_d × (1 - Tax Rate) ≈ 7.04% × (1 - 0.40) ≈ 4.22%.

Cost of Preferred Stock

The preferred stock pays a dividend of 6% on a $100 par value, equaling $6 annually. The stock is expected to sell at $102 before costs, and flotation costs are $4 per share.

The net proceeds per preferred share are: $102 - $4 = $98.

The cost of preferred stock (r_ps) is calculated as:

r_ps = Dividend / Net proceeds = $6 / $98 ≈ 6.12%.

Cost of Retained Earnings

The firm expects to have $100,000 of retained earnings available for the upcoming year. Since the firm does not pay dividends currently, the cost of retained earnings is estimated using the dividend growth model, which incorporates dividend forecast and growth rate:

r_e = (D_1 / P_0) + g

Where D_1 = next year's dividend = $3.25, P_0 = current stock price = $35, and g = 5%.

Thus:

r_e = ($3.25 / $35) + 0.05 ≈ 0.0929 + 0.05 = 0.1429 or 14.29%.

Cost of New Common Stock

The cost of issuing new common stock (r_new) is estimated via the dividend growth model adjusted for flotation costs:

r_new = (D_1 / (P_0 - F)) + g

Where F is flotation cost per share, approximately $2.

Adjusted price = $35 - $2 = $33.

r_new = ($3.25 / $33) + 0.05 ≈ 0.0985 + 0.05 = 14.85%.

Weighted Average Cost of Capital (WACC) Using Retained Earnings

The firm's capital structure weights are 35% debt, 12% preferred stock, and 53% common equity. Using the costs calculated above, the WACC considering retained earnings (which is equivalent to the cost of equity in this case) is:

WACC = (Weight of debt × After-tax cost of debt) + (Weight of preferred × Cost of preferred) + (Weight of equity × Cost of retained earnings)

WACC = (0.35 × 4.22%) + (0.12 × 6.12%) + (0.53 × 14.29%) ≈ 1.48% + 0.74% + 7.58% ≈ 9.80%.

Weighted Average Cost of Capital Using New Common Stock

If the firm issues new common stock, the cost increases to approximately 14.85%, and the capital structure might shift accordingly. Assuming the structure remains at 35% debt, 12% preferred, and 53% new equity, the WACC becomes:

WACC = (0.35 × 4.22%) + (0.12 × 6.12%) + (0.53 × 14.85%) ≈ 1.48% + 0.74% + 7.87% ≈ 10.09%.

Implications of Changes in Capital Structure

Shifting from a mix including preferred stock to more debt increases the firm's leverage, which generally elevates the risk for equity holders and raises the beta coefficient (from a beta of 1.3 to 1.5 in this scenario). This increase in leverage results in a higher cost of equity due to increased financial risk. The new cost of equity can be estimated using the Capital Asset Pricing Model (CAPM):

r_e = Risk-Free Rate + Beta × Market Risk Premium

Market risk premium = 13% - 4% = 9%.

Original cost of equity: r_e = 4% + 1.3 × 9% = 4% + 11.7% = 15.7%.

New cost of equity (after leverage increase): r_e = 4% + 1.5 × 9% = 4% + 13.5% = 17.5%.

Conclusion

Calculating the specific costs associated with various capital sources is vital to effective financial management. Utilizing these calculations, Nova Corporation can optimize its capital structure by balancing debt, preferred stock, and equity to minimize its WACC, thus increasing firm value. The analysis underscores the importance of understanding both the individual component costs and their impact on the overall cost of capital. Adjustments in the capital structure, such as increased leverage, result in elevated risk and higher costs of equity, which must be carefully considered in strategic financial planning.

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