Question

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 35 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

Historically, the corporation’s earnings and dividends per share have increased about 5.6 percent annually and this should continue in the future. Northwest’s common stock is selling at $66 per share, and the company will pay a $8.50 per share dividend (D₁).

The company’s $100 preferred stock has been yielding 10 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $4.00 for preferred stock.

The company’s optimum capital structure is 35 percent debt, 15 percent preferred stock, and 50 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.

   

Data on Bond Issues
Issue	Moody’s Rating		Price	Yield to Maturity
Utilities:
Southwest electric power––7 1/4 2023	Aa2	$	905.18		8.34	%
Pacific bell––7 3/8 2025	Aa3		893.25		8.93
Pennsylvania power & light––8 1/2 2022	A2		980.66		8.99
Industrials:
Johnson & Johnson––6 3/4 2023	Aaa		900.24		8.35	%
Dillard’s Department Stores––7 1/8 2023	A2		980.92		8.55
Marriott Corp.––10 2015	B2		1,045.10		9.55

a. Compute the cost of debt, K_d. (Use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

b. Compute the cost of preferred stock, K_p. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

c. Compute the cost of common equity in the form of retained earnings, K_e. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

d. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

Answer 1

a.) Cost of debt

cost of debt is yield to maturity of the debt or bonds. Northwest Utility Company has an Aa3 credit rating. in the table given in the question on bond issues for comparative yields on bonds of equal risk to Northwest, Pacific bell has an issue under Utilities and its issue has a similar credit rating of Aa3. its yield to maturity is 8.93%.

So, Northwest Utility Company's debt will also have same yield to maturity of 8.93% which will be its cost of debt.

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

After-tax cost of debt = 8.93% * (1 - .35)

After-tax cost of debt =.0580 or 5.80%

b.) Cost of Preferred Stocks

Cost of Preferred Stocks = Dividend Per Share ÷ (Market Price Per Share – Floatation cost)

Dividend Per Share = $100 × 10% = $10

Therefore,

Cost of preferred stock = $10 ÷ ($100 - $4)

= 10.42%

c.) cost of equity using Gordon constant growth model

the equation for the cost of equity using Gordon constant growth model is:

Ks = D1 / P0 +g

Where,

Ks =cost of retrained earnings financing

D1= Dividend per share at time 1

  P0=market price per share at time 0

g = expected dividend growth rate

Here,

D1 = $8.50

P0= $66

g = 5.6%

Ks = (8.50 / 66) + 5.6%

`Ks = 0.1288 + .056

Ks = .1848 OR 18.48%

Cost of equity = 18.48%

d.) Weighted average cost of capital

Source of Funds	weight(W)	After tax cost (c)	WACC(W*C)
Common Stock	.5	18.48%	9.24%
Bonds	.35	5.80%	2.03%
Proffered stock	.15	10.42%	1.56%
Total	1		12.83%

Therefore WACC = 12.83%