Question

Assignment 5 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: 30?% long-term debt,15?% preferred? stock, and 55?% common stock equity? (retained earnings, new common? stock, or? both). The? firm's tax rate is 30?%.

Debt The firm can sell for ?$970 a 10-year, ?$1,000 -par-value bond paying annual interest at a 8.00?% coupon rate. A flotation cost of 2?% of the par value is required in addition to the discount of ?$30 per bond.

Preferred stock??7.50?%? (annual dividend) preferred stock having a par value of ?$100 can be sold for ?$70. An additional fee of $3 per share must be paid to the underwriters.

Common stock??The? firm's common stock is currently selling for ?$80 per share. The dividend expected to be paid at the end of the coming year? (2016) is ?$2.94 Its dividend? payments, which have been approximately 40?% of earnings per share in the past 5? years, were as shown in the following? table:

Year Dividend

2015   $2.72
2014   $2.52
2013   $2.33
2012   $2.16
2011   $2.00

It is expected that to attract? buyers, new common stock must be underpriced ?$5 per? share, and the firm must also pay ?$4.00 per share in flotation costs. Dividend payments are expected to continue at 40?% 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

Given weight of components of capital structure:

Common stock= 55%

Preferred stock= 15%

Debt= 30%

a) Cost of Debt (after tax) = 8% (1-0.30) =5.60%

Note: Floating costs are not considered in case of debt.

b)Cost of  preferred stock= dividend per share (for next year)/ current market price of preferred stock (after deducting any cost of issuing)

Given

Dividend per share=$7.5

Stock can be sold at = $70

Floating cost= $3 per share (3%)

                                   = 7.50/70- (1-0.03) = 11.04%

c) Cost of common stock= dividend per share (for next year)/ current market price of stock + dividend growth rate

Dividend growth rate is as follows;

Years 2011 2012 2013 2014 2015 2016 Dividend paid 2 2.16 2.33 2.52 2.72 2.94 Growth rate NA 0.08 0.078704 0.081545 0.079365 0.080882

On average growth rate is 8%

DPS= $2.94

Current stock price= $80 per share

Hence., cost of common stock is: 2.94/80 + 8% = 3.675% + 8% =11.675%

d) WACC = cost of equity* weight of equity + cost of preferred stock* weight of preferred stock + cost of debt after tax* weight of debt

                =11.675*0.55 +11.04*0.15 + 5.60*0.30

                = 6.42125 + 1.656 + 1.68

     WACC= 9.7572%