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?

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%