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: 30​% ​long-term debt, 10​% preferred​ stock, and 60​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 26​%.

Debt The firm can sell for ​$1030 a 20​-year, ​$1,000 ​-par-value bond paying annual interest at a 7.00​% coupon rate. A flotation cost of 2.52% of the par value is required.

Preferred stock 10.00​% ​(annual dividend) preferred stock having a par value of ​$100 can be sold for ​$96 . An additional fee of ​$2 per share must be paid to the underwriters.

Common stock  The​ firm's common stock is currently selling for ​$90 er share. The stock has paid a dividend that has gradually increased for many​ years, rising from ​$2.25 ten years ago to the ​$3.67 dividend​ payment D0​, 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 ​$3.50 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

Answer (a):

The firm can sell for ​$1030 a 20​-year,​$1,000 ​-par-value bond paying annual interest at a 7.00​% coupon rate. A flotation cost of 2.52% of the par value is required.

Flotation cost =2.52% of the par value

Realized price = 1030 - 1000 * 2.52% = $1004.80

Annual coupon amount = 1000 * 7% = $70

Number of years = 20

Hence:

Before tax cost of debt = RATE (nper, pmt, pv, fv, type) = RATE (20, 70, -1004.80, 1000, 0) = 6.9549%

After-tax cost of debt = Before tax cost of debt *(1 - Tax rate) = 6.9549% * (1 - 26%) = 5.15%

After-tax cost of debt = 5.15%

Answer (b):

Annual Preference dividend = $100 * 10% = $10

Cost of preferred stock = Annual dividend /(Price - Underwriter fees) = 10 / (96 - 2) = 10.64%

Cost of preferred stock = 10.64%

Answer (c):

D0 = $3.67

Growth rate of dividend = (3.67 / 2.25) ^1/10 - 1 = 5.01%

Cost of new common stock = (3.67 * (1 + 5.01%) / (90 - 2 - 3.50)) + 5.01% = 9.57%

Cost of retained earnings = (3.67 * (1 + 5.01%) / 90) + 5.01% = 9.29%

Cost of new common stock = 9.57%

Cost of retained earnings = 9.29%

Answer (d):

WACC = Cost of new common stock * weight if equity + Cost of preferred stock * weight if preferred stock + After-tax cost of debt * weight of debt

WACC( with new common stock) = 9.57% * 60% + 10.64% * 10% + 5.15% * 30​% = 8.35%

WACC (with retained earnings) = 9.29% * 60% + 10.64% * 10% + 5.15% * 30​% = 8.18%

Hence:

WACC(with new common stock) = 8.35%

WACC(with retained earnings) = 8.18%