Question

  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:

45%

​long-term debt,

15​%

preferred​ stock, and

40​%

common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is

23​%.

Debt The firm can sell for

​$1015

a

12-year,

​$1,000​-par-value

bond paying annual interest at a

7.00​%

coupon rate. A flotation cost of

44​%

of the par value is required.

Preferred stock  

8.00%

​(annual dividend) preferred stock having a par value of

​$100

can be sold for

​$88

An additional fee of

​$5

per share must be paid to the underwriters.

Common stock  The​ firm's common stock is currently selling for

​$60

per share. The stock has paid a dividend that has gradually increased for many​ years, rising from

​$2.75

ten years ago to the

​$4.70

dividend​ payment,

Upper D 0D0​,

that the company just recently made. If the company wants to issue new new common​ stock, it will sell them

​$2.00

below the current market price to attract​ investors, and the company will pay

​$4.00

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.

a.  The​ after-tax cost of debt using the​ bond's yield to maturity​ (YTM) is _____ ​%.

​(Round to two decimal​ places.)

The​ after-tax cost of debt using the approximation formula is ____%.

​(Round to two decimal​ places.)

b.  The cost of preferred stock is _____ ​%.

​(Round to two decimal​ places.)

c.  The cost of retained earnings is ____​%.

​(Round to two decimal​ places.)

The cost of new common stock is _____​%.

​(Round to two decimal​ places.)d.  

Using the cost of retained​ earnings, the​ firm's WACC is ____%.

​(Round to two decimal​ places.)

Using the cost of new common​ stock, the​ firm's WACC is

___ ​%.

​(Round to two decimal​ places.)

Answer 1

a) IN THE GIVEN CASE COST OF DEBT AFTER TAX  IS CALCULATED BASED ON YTM FORMAL MODEL

YTM FORMULA = C+F-P/N

P+F/2

C = COUPON AMOUNT

F = FACE VALUE

P = CURRENT PRICE

N = NUMBER OF YEARS

GIVEN VALUES SUBMITTED

C = $1000*7% =$70

F = $1000

P = $1015

N = 12 YEARS

YTM = 70+(1000-1015)/12 / 1000+1015/2

YTM = 68.75/1007.5

= 0.0682

YTM (%) = 0.0682*100

= 6.82 %

COST OF DEBT AFTER TAX = (1-0.23)*6.82 %

= 5.25 %

b) IN THE GIVEN CASE CALCULATION OF COST OF PREFERENCE STOCK

COST OF PREFERENCE STOCK FORMAL = DIVIDEND /MARKET PRICE (1-FLOTATION)

DIVIDEND = $100*8% =$8

CURRENT PRICE = $ 88

FLOTATION = 44%

THE ABOVE ALL THE INFORMATION INTRODUCE IN FORMAL

COST OF PREFERENCE STOCK = $ 8/ $88(1-0.44)

= 0.1623

COST OF PREFERENCE STOCK (%) = 0.1623 *100

= 16.23 %

C)  

IN THE GIVEN CASE CALCULATION OF COST OF RETAIN EARNINGS AND COST OF NEW STOCKS

COST OF RETAIN EARNINGS FORMAL =DIVIDEND/CURRENT SHARE PRICE

DIVIDEND = $4.7

CURRENT SHARE PRICE = $ 60

COST OF EARNINGS = $4.7/ $60

= 0.07833

COST OF EARNINGS (%) = 0.07833*100

= 7.83 %

COST OF NEW STOCKS IS ISSUED BELOW THE CURRENT MARKET PRICE THAT TIME PRICE VALUE CHANCED

FORMULA =DIVIDEND / NET CURRENT MARKET PRICE

DIVIDEND = $4

NET CURRENT MARKET PRICE = $60-$2 = $58

COST OF STOCK = $4/$58

= 0.06896

COST OF STOCK (%) = 0.06896*100

= 6.89%

d)

( i )

WACC (RETAIN EARNINGS)

FORMAL WACC =W1*COST OF STOCK %+W2* COST OF PREFERENCE STOCK % +W3* CT OOST OF DEBT %

WHERE

W1 = WEIGHT OF STOCK / RETAINS  = 40%

W2 = WEIGHT OF PREFERENCE STOCK = 15%

W3 = WEIGHT OF DEBT STOCK = 45%

WACC = 0.4*7.83%+0.15*16.23%+0.45*5.25%

=7.929 %

(ii)

WACC (NEW STOCK)

USING ABOVE FORMAL

WACC= 0.4*6.89%+0.15*16.23%+0.45*5.25%

= 7.55 %