Question

Calculation of individual costs and WACC:   Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following​ weights: 40% ​long-term debt, 15​% preferred​ stock, and 45% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 26​%.

Debt The firm can sell for ​$1010 a 17​-year, ​1,000​-par-value bond paying annual interest at a 8.00​% coupon rate. A flotation cost of 3​% of the par value is required.

Preferred stock  9.00​% ​(annual dividend) preferred stock having a par value of ​$100 can be sold for ​$98. An additional fee of ​$4 per share must be paid to the underwriters.

Common stock  The​ firm's common stock is currently selling for ​$80 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from ​$2.75 ten years ago to the ​$4.07 dividend​ payment, D0​, that the company just recently made. If the company wants to issue new new common​ stock, it will sell them ​$2.50 below the current market price to attract​ investors, and the company will pay ​$2.50 per share in flotation costs.  

a.  Calculate the​ after-tax cost of debt.

b.  Calculate the cost of preferred stock.

c.  Calculate the cost of common stock​ (both retained earnings and new common​ stock).

d.  Calculate the WACC for Dillon Labs

Answer 1

a). Cost of debt: Flotation cost = 3%*par value = 3%*1,000 = 30

Net price of the bond = price - flotation cost = 1,010 - 30 = 980

FV = 1,000; PV = -980; PMT (coupon payment) = coupon rate*par value = 8%*1,000 = 80; N = 17, CPT RATE.

YTM = 8.22%

After-tax cost of debt = YTM*(1-Tax rate) = 8.22%*(1-26%) = 6.08%

b). Cost of preferred stock = annual dividend/(current price - flotation cost)

annual dividend = 9%*par value = 9%*100 = 9

Cost of preferred stock = 9/(98-4) = 9.57%

c). Current share price (P0) = 80; Dividend (D0) = 4.07

Growth rate over 10 years = (4.07/2.75)-1 = 48.00%

Annual growth rate (g) = ((1+48%)^(1/10)) -1 = 4.00%

Cost of retained earnings = (D1/P0) + g = (D0*(1+g)/P0) + g

= (4.07*(1+4%)/80) + 4% = 9.29%

Cost of new stock: Net price (Np) = P0 - 2.50 - 2.50 = 80 - 5 = 75

Cost of new stock = (D1/Np) + g = (4.07*(1+4%)/75) + 4% = 9.64%

d). WACC calculation:

WACC using retained earnings:

	Weight (w)	Cost ('c)	w*c
Debt	40%	6.08%	2.43%
Preferred stock	15%	9.57%	1.44%
Retained earnings	45%	9.29%	4.18%
WACC			8.05%

WACC using new common stock:

	Weight (w)	Cost ('c)	w*c
Debt	40%	6.08%	2.43%
Preferred stock	15%	9.57%	1.44%
Common stock	45%	9.64%	4.34%
WACC			8.21%