**Problem Statement:** ABC Limited plans to raise 15,000,000 shs through various financial instruments. We need to compute: 1. Cost of Debt, Cost of Preferred Stock, Cost of New Common Stock, and Cost of Retained Earnings. 2. Weighted Average Cost of Capital (WACC). 3. Comment on the importance of Cost of Capital. --- ### 1. Compute the individual costs **Given:** - Bank Loan: 3,000,000 at 15% for 3 years - Corporate Bonds: 2,000,000 at 3%, bond price 105 - Preferred Stock: 3,000,000 at 5%, preferred stock price 118, flotation cost 3 - Common Stock: 5,000,000 at last dividend 4.00, growth 2.5%, stock price 48.50, flotation cost 2 - Retained Earnings: 2,000,000 - Tax rate = 30% - Total Capital = 15,000,000 **Step 1: Cost of Debt** Cost of debt is based on after-tax interest expense. For the bank loan (simple 15% interest rate, assuming interest is the cost): $$ r_{bank} = 15\% \times (1 - 0.30) = 15\% \times 0.7 = 10.5\% $$ For the corporate bonds: - Coupon payment = 3% of face value 100 = 3 - Market price = 105 Pretax cost of bond = $$ \frac{Coupon}{Price} = \frac{3}{105} = 2.857\% $$ After tax: $$ r_{bonds} = 2.857\% \times (1 - 0.30) = 2.0\% $$ Since the bond cost is lower, the overall cost of debt is the weighted average: Total debt = 3,000,000 + 2,000,000 = 5,000,000 Weighted cost of debt: $$ r_d = \frac{3,000,000}{5,000,000} \times 10.5\% + \frac{2,000,000}{5,000,000} \times 2.0\% = 6.3\% + 0.8\% = 7.1\% $$ **Step 2: Cost of Preferred Stock ($r_{ps}$)** Formula considering flotation cost: $$ r_{ps} = \frac{Dividend}{Price - Flotation} = \frac{5\% \times 120}{118 - 3} = \frac{6}{115} = 5.22\% $$ Here dividend = 5% of sh.120 = sh.6 **Step 3: Cost of New Common Stock ($r_{ns}$)** Dividend growth model with flotation cost: Last dividend $$D_0 = 4.00$$ Growth rate $$g = 2.5\% = 0.025$$ Price net flotation cost: $$ P_0 - F = 48.50 - 2 = 46.50 $$ Next dividend: $$ D_1 = D_0 \times (1 + g) = 4.00 \times 1.025 = 4.10 $$ Cost: $$ r_{ns} = \frac{D_1}{P_0 - F} + g = \frac{4.10}{46.50} + 0.025 = 0.08817 + 0.025 = 0.11317 = 11.32\% $$ **Step 4: Cost of Retained Earnings ($r_{re}$)** Assuming no flotation cost for retained earnings: Use dividend growth model: $$ r_{re} = \frac{D_1}{P_0} + g = \frac{4.10}{48.50} + 0.025 = 0.0845 + 0.025 = 10.95\% $$ --- ### 2. Compute Weighted Average Cost of Capital (WACC) Calculate market value weights: - Debt market value = loan + bonds = 3,000,000 + 2,000,000 = 5,000,000 - Preferred stock market value = Number of shares * price per share Preferred stock value given = 3,000,000 (already market value) - Common stock market value = 5,000,000 shares * 48.50 price = 242,500,000 (but problem's data suggests 5,000,000 shs raised at sh.50 par, so use the market price given 48.50 for weights) Wait, capital raised is 5,000,000 shs for common stock. Use market price to find weight: Total capital raised = 15,000,000 Calculate weights: $$ w_d = \frac{5,000,000}{15,000,000} = 0.3333 $$ $$ w_{ps} = \frac{3,000,000}{15,000,000} = 0.20 $$ $$ w_{cs} = \frac{5,000,000}{15,000,000} = 0.3333 $$ $$ w_{re} = \frac{2,000,000}{15,000,000} = 0.1333 $$ WACC: $$ WACC = w_d \times r_d + w_{ps} \times r_{ps} + w_{cs} \times r_{ns} + w_{re} \times r_{re} $$ Calculate: $$ = 0.3333 \times 7.1\% + 0.20 \times 5.22\% + 0.3333 \times 11.32\% + 0.1333 \times 10.95\% $$ $$ = 2.367 + 1.044 + 3.773 + 1.46 = 8.64\% $$ --- ### 3. Comment on importance of Cost of Capital 1. Cost of capital helps the company decide on appropriate financing mix by comparing costs. 2. It serves as a benchmark for investment decisions; projects should yield returns higher than this cost to create value. 3. It guides dividend policy and growth planning by indicating the minimum required return to satisfy investors. 4. Essential for valuation models to determine firm value and assess project viability. --- **Final Answers:** - Cost of Debt = 7.1% - Cost of Preferred Stock = 5.22% - Cost of New Common Stock = 11.32% - Cost of Retained Earnings = 10.95% - Weighted Average Cost of Capital (WACC) = 8.64%