Reference no: EM132693494

HK to raise approximately $20mil to finance new division.

• HK's capital structure consists of a single long-term debt issue with a face value of $20 million and 2 million common shares with a current market price of $15 per share.
• The long-term debt issue carries a coupon rate of 5% with interest paid semi-annually. It has eight years remaining until maturity and a current market yield of 6%, also based on semi-annual compounding.
• The common shares have a beta of 1.15. HK paid a dividend of $0.95 per share in its most recently completed financial year. Analysts believe these dividends will grow at an average annual rate of 3% for the foreseeable future. The current risk-free interest rate is 2.5%, and the market price of risk is 6%.
• Recent discussions with HK's investment banker have indicated that flotation costs would be 7% before tax on any new issue of common shares and 4% after tax on any new issue of long-term debt.

Question

Problem 1: What is HK's weighted average cost of capital (WACC), assuming its cost of common equity will be determined using the CAPM and it will issue new common shares? Round market values to the nearest thousand. (Treat the yield on debt as an annual rate for this purpose.)

Problem 2:  Is the decision to raise approximately $20 million to finance the new division exclusively using new equity likely to affect HK's WACC? Explain why or why not in terms of financial leverage, component costs, and capital structure. What is the likely impact? (Note: A recalculation of the WACC is not required for this question.)