Question

Davola Inc. has the following financial information: • Debt: The firm issued 1,000, 20 year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 8.4%. • Preferred Stock: Pays a 9.75% preferred dividend with a par of $100 and is currently selling for $86. • Equity: Davola’s common stock currently sells for $72 and grows at a constant rate of 6%. Davola just paid a $4.65 dividend to their shareholders. • Davola’s business plan for next year projects net income of $360,000, half of which will be retained. • The company applies an average tax rate of 35% for cost of capital decision-making purposes. • Dovola Inc. pays flotation costs of 10% on all new stock issues. • Dovola’s capital structure is 40% debt, 15% preferred stock and 45% common equity.

a. Compute the capital component costs for each of the capital components. Ignore flotation costs for debt and preferred stock.

b.   Calculate the WACC before the break in retained earnings.

c.   Calculate Davola’s break point in retained earnings.

d.   Calculate the WACC after the break in retained earnings. In other words, calculate the WACC given the            point that the firm will have to issue new stock to fund the equity portion of its capital budget.

Answer 1

1. Cost of Debt = 8.40% (Because the Bonds are Selling at Par the cost of debt will be equal to Coupon rate)

Cost of Preferred Stock Dividend = Preferred Dividend / Market Price = $100 * 9.75% / 86 = 11.34%

Cost of Common Stock = (Dividend in Next Year / Price of Stock) + Growth rate

Cost of Common Stock = (4.65 * 1.06 / 72) + 0.06

Cost of Common Stock = 12.85%

b. WACC before break-in retained earnings = Weight of Equity * Cost of Equity + Weight of Debt * Cost of debt * (1 - Tax) + Weight of Preferred Stock * Cost of Preferred Stock

WACC before break-in retained earnings = 0.45 * 0.1285 + 0.40 * 0.0840 * (1 - 0.35) + 0.15 * 0.1134

WACC before break-in retained earnings = 9.67%

c. Retained Earnings Break Point = Earnings * Retention / Retention % = 180000 / 0.5 = $ 360000

d. Cost of Equity with flotation cost = (Dividend in Next Year / (Price of Stock* (1 - F))) + Growth rate=

Cost of Equity with flotation cost = [4.65*1.06 / 72 x (1-0.1)] + 0.06 = 13.61%

WACC After break-in retained earnings = Weight of Equity * Cost of Equity + Weight of Debt * Cost of debt * (1 - Tax) + Weight of Preferred Stock * Cost of Preferred Stock

WACC After break-in retained earnings = 0.45 * 0.1361 + 0.40 * 0.0840 * (1 - 0.35) + 0.15 * 0.1134

WACC After break-in retained earnings = 10.01%