Question

P9–17 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, 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 $980 a 10-year, $1,000-par-value bond paying annual
interest at a 10% coupon rate. A flotation cost of 3% of the par value is required
in addition to the discount of $20 per bond.
Preferred stock Eight percent (annual dividend) preferred stock having a par
value of $100 can be sold for $65. An additional fee of $2 per share must be paid
to the underwriters.
Common stock The firm’s common stock is currently selling for $50 per share.
The dividend expected to be paid at the end of the coming year (2016) is $4. Its
dividend payments, which have been approximately 60% of earnings per share in
each of the past 5 years, were as shown in the following table.
Year Dividend
2015 $3.75
2014 3.50
2013 3.30
2012 3.15
2011 2.85

It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings. (Assume that rr = rs.)
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the WACC for Dillon Labs.

Answer 1

Annual average growth rate=((last value/First value)^(1/Time between 1st and last value)-1)*100

Annual Growth rate=((3.75/2.85)^(1/4)-1)*100

Annual Growth rate% = 7.1 = growth rate of dividends

a

Cost of debt

K = N

Bond Price *(1-flotation %) =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

980*(1-0.03) =∑ [(10*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM = 10.8329522127

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 10.8329522127*(1-0.4)

= 6.50

b

cost of preferred equity

cost of preferred equity = Preferred dividend/price-flotation cost*100

cost of preferred equity = 8/(63-2)*100

=12.7

c

Cost of equity

As per DDM

Price-flotation cost= Dividend in 1 year/(cost of equity - growth rate)

50-8 = 4/ (Cost of equity - 0.071)

Cost of equity% = 16.62

d

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=6.5*0.4+16.62*0.5+12.7*0.1

WACC =12.18%