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Question 31
Island Capital has the following capital structure

Bonds: $20,000,000
Perpetuals (preferred shares): $ 4,000,000
Common shares: $20,000,000
Retained earnings: $19,500,000
The existing bonds have a coupon rate of 8 percent with 18 years left to maturity, but current yields on these bonds are 11 percent. Flotation costs of $25 per $1,000 bond would be expected on a new issue.
The existing perpetuals have a $25 par value and an annual dividend rate of 9 percent. New perpetuals could be issued at a $50 par value with an 8 percent yield. Flotation costs would be 3 percent.
There are 4 million common shares outstanding that currently trade at $18 per share and expect to pay a dividend next year of $1.75 that will continue to grow at 7 percent per annum for the foreseeable future. New shares could be issued at $17.50 and would require flotation expenses of 5 percent of proceeds.
Island’s tax rate is 39 percent, and it is expected that internally generated funds will be sufficient to fund capital projects in the near future.
a) Compute Island Capital’s current cost of capital with market value weightings.
b) How would the cost of capital calculation change if new shares are required to fund the equity component of the capital structure?

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Question 32
Trois-Rivieres Manufacturing (TRM) has 10,000 bonds (face value of $1,000 each) with a 10 percent coupon maturing in 8 years. Its preferreds (100,000 shares) pay a 7.5 percent dividend and it has 600,000 common shares outstanding. Retained earnings are reported at $4,500,000.
During the past five years, TRM has enjoyed steady growth, with common stock dividends growing from $0.80 to $1.23 (just recently paid). The common share price currently trades at $15. If new shares were issued at $15, they would require flotation expenses of 7 percent of proceeds.
The preferred shares currently trade at $26.50, and any new issue would require flotation expenses of 5 percent of price to investors.
The bonds currently pay interest semiannually and are trading at a price that yields a nominal12 percent annual rate (12.36 effective annual rate). Flotation costs of new debt would be 4 percent of proceeds.
TRM’s tax rate is 38 percent, and equity financing would require a new share issue. Calculate the weighted average cost of capital of TRM.
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