Question 3 (25 Marks)
(a) Burst Plc. is a distribution company operating in Mandeville. Their optimal capital
structure is a follows:
Debt 30%
Preferred Stock 20%
Common Equity 50%
The following additional information is available:
The tax rate is 30%.
Earnings and dividends on common stock is expected to grow at a constant rate of 6% in the
future. The company expects to pay a dividend of $4.00 per share on common stock next
year, and its common stock currently sells at a price of $40 per share.
Preferred stock pays a dividend of $15 and can be sold to the public at a price of $80 per
share.
The yield to maturity on debt is 8%.
(i) Calculate the cost of each of the following capital components:
(a) The after tax cost of debt (2 marks)
(b) The cost of common equity (3 marks)
(c) The cost of preferred stock (3 Marks)
(ii) Calculate the Weighted Average Cost of Capital (WACC) (5 Marks)
(b) Plums Ltd. earnings and stock price are expected to grow at a rate of 4% per year. Their
common stock currently sells for $15.00 per share, and the dividend next year is expected to
be $2.00. A flotation cost of 5% will be paid for raising new common equity.
i. Using the information provided, calculate the cost of internal equity ($k_s$). (4 marks)
ii. Using the information provided, calculate the cost of external equity ($k_e$). (4 marks)
iii. If the firm's beta is 1.15, risk-free is 4.5%, and the market risk premium is 5%, what
will be the firm's cost of common equity using the CAPM approach? (4 marks)
