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, 20​% preferred​ stock, and 40​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 26​%.

Debt The firm can sell for ​$1010 a 12​-year, ​$1,000​-par-value bond paying annual interest at a 8.00​% coupon rate. A flotation cost of 2.5​% of the par value is required.

Preferred stock  8.00​% ​(annual dividend) preferred stock having a par value of $100 can be sold for $92. An additional fee of $6 per share must be paid to the underwriters.

Common stock  The​ firm's common stock is currently selling for $90 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from $2.70 ten years ago to the ​$5.07 dividend​ payment, Upper 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 $3.00 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

before tax cost of debt =Using rate function in MS excel	rate(nper,pmt,pv,fv,type) nper = 12 pmt =1000*8% =80 pv =1010-25 =-985 fv =1000 type =0	RATE(12,-80,985,-1000,0)	8.20%
1-after tax cost of debt = before tax cost of debt*(1-tax rate)	8.20*(1-.26)		6.068
2-cost of preferred stock	preferred dividend/net proceeds	9/(92-6)	10.47%
3-cost of common stock-retained earnings	(expected dividend/market prices)+growth rate	(5.4/90)+6.5%	12.50%
cost of common stock -new	(expected dividend/net proceeds)+growth rate	(5.4/85)+6.5%	12.85%
expected dividend	current dividend*(1+growth rate)	5.07*1.065	5.400
growth rate	(current year dividend/dividend in 10 year back)^(1/n)-1	(5.07/2.7)^(1/10)-1	6.50%
net proceeds	market price-flotation cost-discount	90-2-3	85
4-WACC - Using new stock
source	weight	component cost	weight*component cost
debt	0.4	6.068	2.4272
preferred stock	0.2	10.47	2.094
common stock	0.4	12.85	5.14
total		WACC = sum of weight*component cost	9.66
4-WACC - Using retained earning
source	weight	component cost	weight*component cost
debt	0.4	6.068	2.4272
preferred stock	0.2	10.47	2.094
common stock	0.4	12.5	5
total		WACC = sum of weight*component cost	9.52