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What are some of the advantages and disadvantages of raising capital by using debt?
A company is looking to finance a project with $5 million of common stock, $3 million of preferred stock, and $10 million of corporate bonds. The risk-free rate is 3% and the expected rate of return on the overall stock market is 8%. The beta of the common stock is 0.78. The cost of the preferred stock is 8.5%. The company’s bonds have a coupon rate of 6%, a time to maturity of 12 years, a $1,000 par value, and currently sell for $840. Interest on the bonds is due every six months. The firm’s tax rate is 35%.
What’s the weighted average cost of capital for this project?
Also, answer these qualitative questions:
- How would “floatation costs” impact the WACC?
- If the after-tax cost of debt is always less expensive than equity, why don’t firms always use a lot of debt and little equity?
- What are some of the advantages and disadvantages of raising capital by using debt?