Cost of capital

Case Study I: (Marks 10)
Fatimah Enterprises
Fatimah Enterprises (FE) transforms manual accounting and inventory systems into computerized, more efficient, systems. Many of their customers describe the transition as an overnight evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with respects to both time and inventory control. FE’s computerized inventory systems, for example, allow every item in inventory, no matter how small, to be tracked at all points throughout the production process. Replenishing stock becomes an automatic process because the FE system alerts the manager when supplies reach a pre-programmed level.
Fatimah Imran has been a financial analyst with FE for over five years. Although she normally does not get involved with sales, her most recent assignment was to assist Kashif Khan, a new sales representative. Kashif is in the process of trying to sell a FE system to Fateh Corporation, a firm that does not know how to determine accurately its weighted average cost of capital (WACC). To calculate Fateh’s WACC, Mehwish first needed to gather information on the firm’s cost of raising funds from various sources. As she proceeded with the analysis, she learned that Fateh Corporation could issue 20-year corporate bonds at a coupon rate of 10%. As a result of current interest rates, the bonds could be sold for Rs.1,050 each. These bonds have floatation costs of 5% per bond, pay interest semi-annually, and have a par value of Rs.1,000 with cost of long-term debt 9.5% per annum.
Fateh Corp can raise additional funds through new issues of preferred stock. Rs.100-par preferred stock can be issued at 10% annual dividend rate. After floatation costs, the preferred stock would sell for Rs.94 per share. A final source from which funds could be raised is via common stock. Their common stock is currently selling for Rs.109 per share. The most recent dividend paid was in the amount of Rs.5. Fateh’s dividends grown at a rate of 12%.
Fateh’s balance sheet at year end showed the following sources of finance:
Asset Class
Market Value
Long-term Debt
Rs.50,000,000
Preferred Stock
17,000,000
Common Stock
70,000,000
A corporate tax rate of 40% applies.
Required:
1. What is the firm’s cost of common equity?
2. What is the firm’s cost of preferred equity?
3. What is the firm’s cost of debt before and after-tax?
4. What is Fateh Corporation’s weighted average cost of capital?

Solution: