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AICPA Exam CPA-Business Topic 3 Question 91 Discussion
Topic #: 3
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.
* Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments.
In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.
* Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
* Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.
* Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
* Williams' preferred capital structure is:
Long-term debt 30%
Preferred stock 20
Common stock 50
The cost of funds from retained earnings for Williams, Inc. is:
Choice 'a' is correct. 7.0 percent cost of funds from retained earnings.
The cost of retained earnings is equal to the rate of return required by the firm's common shareholders (or, in effect, the return 'lost' by them when the firm chooses to fund with retained earnings). While oftentimes this rate is somewhat subjective, we are given the facts to exactly answer the question in this case. The stock is currently selling for $100/share, and the dividend is given at $7/share.
$7 / $100 = 7%
Choices 'b', 'c', and 'd' are incorrect, per the above Explanation:/calculation.
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