DM Enterprises had earnings per share of $3.50 last year. Its common stock sells for $60. Last year’s dividend was $2.40 and a flotation cost of 10% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 7%. DM’s preferred stock pays a dividend of $2.50 per share and its preferred stock sells for $22 per share. The firm can issue long-term debt at an interest rate of 10%, and its marginal tax rate is 35%. The firm’s currently outstanding 10% annual coupon rate long-term debt sells at par value. The market risk premium is 10%, the risk-free rate is 3%, and DM’s beta is 1.4 . The company’s target capital structure is 25% debt, 5% preferred stock and 70% common equity.
a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock and the cost of equity from retained earnings, and the cost of newly issued common stock. Use only the dividend yield plus growth approach to find the cost of equity—for both retained earnings and new shares.
b. Calculate the cost of retained earnings using CAPM.
c. What is the cost of new common stock using the CAPM?
d. Suppose DM Enterprises is equally confident in the estimates for the cost of equity obtained from CAPM and the dividend yield plus growth approach. What should be the cost of retained earnings? Of new shares?
e. If DM maintains the same capital structure, what is the firm’s wacc assuming it uses only retained earnings?
f. If DM maintains the same capital structure, what is the firm’s wacc assuming it expands so fast it must issue new shares?