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?

9.09%

9.327%

Explanation:

For computing the weighted cost of capital first we have to determine the cost of preferred stock, cost of common stock and the after cost of debt is shown below:

The Cost of preferred stock is

= Preferred dividend ÷ market price of preferred stock

= $2.50 ÷ $25

= 10%

The cost of common stock is

= (Expected dividend ÷ market price) + growth rate  

= ($1.50 ÷ $20) + 0.05

= 12.50%

And, the after cost of debt is

= Before cost of debt × (1 - tax rate)

= 0.08 × (1 - 0.35)

= 5.2%

Now the WACC is

= Weightage of debt × cost of debt + (Weightage of preferred stock) × (cost of preferred stock) + (Weightage of  common stock) × (cost of common stock)

= (0.45 × 5.2%) +  (0.05 × 10%) +  (0.50 × 12.5%)

= 2.34 + 0.5 + 6.25

= 9.09%

In the second case, the WACC is

= Weightage of debt × cost of debt + (Weightage of preferred stock) × (cost of preferred stock) + (Weightage of  common stock) × (cost of common stock)

= (0.30 × 5.2%) +  (0.05 × 10%) +  (0.65 × 12.5%)

= 0.702 + 0.5 + 8.125

= 9.327%