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 (WACC). The WACC is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%. Debt: The firm can sell for $1,020 a 10-year, $1,000-par-value bond paying annual interest at a 7% coupon rate. A flotation cost of 3% of the par value is required. Preferred stock: An 8% (annual dividend) preferred stock having a par value of $100 can be sold for $98. An additional fee of $2 per share must be paid to the underwriters. Common stock: The firm’s common stock is currently selling for $59.43 per share. The stock has paid a dividend that has gradually increased for many years, rising from $2.70 ten years ago to the $4 dividend payment that the company just recently made. If the company wants to issue new common shares, it will sell them $1.50 below the current market value to attract inves-tors, and the company will pay $2 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]	Before tax cost of debt = YTM.
	YTM using a calculator = 7.14%
	[Inputs: Price = 1020-30 = 990, i = 7%, n = 10]
	After tax cost of debt = YTM*(1-t) = 7.14%*(1-40%) =	4.28%
b]	Cost of preferred stock = 8/(98-2) =	8.33%
c]	Growth rate in dividends = (4/2.7)^(1/10)-1 =	4.01%
	Cost of retained earnings = D1/P0+g, where D1 =
	growth rate in dividends, P0=Current price and D1
	next expected dividend.
	= 4*1.0401/59.43+0.0401 =	11.01%
	Cost of new common equity = 4*1.0401/(59.43-1.5-2)+0.0401 =	11.45%
d]	WACC is the weighted average of the cost of the component sources of capital. The weights are as given.
	WACC using retained earnings = 4.28%*40%+8.33%*10%+11.01%*50% =	8.05%
	WACC using new common equity = 4.28%*40%+8.33%*10%+11.45%*50% =	8.27%
	WACC using retained earnings and new common equity = 4.28%*40%+8.33%*10%+11.01%*25%+11.45%*25% =	8.16%