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, 10​% preferred​ stock, and 50​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 21​%.

Debt: The firm can sell for ​$1020 a 10​-year, ​$1000​-par-value bond paying annual interest at a 7.00​% coupon rate. A flotation cost of 3​% of the par value is required.

Preferred stock: 8.00​% ​(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 ​$4.00 dividend​ payment, Upper D0​, that the company just recently made. If the company wants to issue new new common​ stock, it will sell them ​$1.50 below the current market price to attract​ investors, and the company will pay ​$2.00 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.

Answer 1

Wd

Weight of Debt

0.40

We

Weight of Common Equity

0.50

Wp

Weight of Preferred stock

0.10

a

Cost of Debt

Sales price of bond

$1,020

Flotation cost=3%*1020

$30.60

Pv

Net amount received per bond

$989.40

(1020-30.60)

Nper

Number of years

10

Pmt

Annual Coupon Payment =1000*7%

$70

Fv

Payment at maturity

$1,000

RATE

Before Tax Cost of Bonds

7.15%

(Using RATE function of excel with Nper=10, Pmt=70, Pv=-989.40,Fv=1000)

a.

Cd

After tax cost of Bonds =7.15*(1-tax rate)

5.65%

(7.15*(1-0.21)

b.

Cost of Preferred Stock

Selling price per share

$98

Underwriters fees

$2

Net amount received per share

$96

Annual Dividend payment=8%*100

$8

Cp

Cost of Preferred Stock=8/96=

8.33%

c.

Required Return on Common Equity=Ce

D0=Current Dividend

$4.00

g=dividend growth rate =((4/2.70)^(1/10))-1

4.0%

0.04

P0=Current market Price =$59.43

Next years Dividend =D1=4*1.04

$4.16

Price paid =59.43-1.5=

$57.93

Flotation Cost

$2

Net amount per share received

$55.93

Cost of Equity =(D1/55.93)+g

Ce=(4.16/55.93)+0.04

11.45%

Ce

Cost of Equity

11.45%

d

Weighted Average Cost of Capital (WACC)=Wd*Cd+We*Ce+Wp*Cp

Weighted Average Cost of Capital (WACC)=0.4*5.65+0.5*11.45+0.1*8.33

WACC=

8.82%