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 6.2 percent annually and this should continue in the future. Northwest’s common stock is selling at $63 per share, and the company will pay a $5.50 per share dividend (D₁).

The company’s $94 preferred stock has been yielding 7 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $5.00 for preferred stock.

The company’s optimal capital structure is 45 percent debt, 25 percent preferred stock, and 30 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	$	890.18		8.64	%
Pacific bell––7 3/8 2025	Aa3		890.25		8.63
Pennsylvania power & light––8 1/2 2022	A2		965.66		8.66
Industrials:
Johnson & Johnson––6 3/4 2023	Aaa		870.24		8.44	%
Dillard’s Department Stores––7 3/8 2023	A2		950.92		8.33
Marriott Corp.––10 2015	B2		1,030.10		9.96

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.)
  

Cost of debt: ___%

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.)
  

Cost of preferred stock:___%

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.)
  

Cost of common equity:____%

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.)

	Weighted Cost	%
Debt
Preffered Stock
Common Equity
Weighted average cost of capital		%

Answer 1

Solution:
a.	Cost of debt = 5.61%
Working Notes:
	cost of debt (Kd) = YTM of Bond x (1-tax rate)
	Since, Northwest Utility Company , bond YTM cannot be calculated as , there is no details of its own Bond for YTM calculation , so We choose the best comparative, and Pacific bell bond is best comparable as both company have same ratings of Aa3, and Bond YTM mostly depend on ratings, So Northwest Utility Company Bond YTM = 8.63%
	cost of debt (Kd) = YTM of Bond x (1-tax rate)
	cost of debt (Kd) = 8.63% x (1- 0.35)
	cost of debt (Kd) = 8.63% x 0.65
	cost of debt (Kd) = 5.6095 %
	cost of debt (Kd) = 5.61 %
b.	cost of preferred stock =7.39%
Working Notes:
	cost of preferred stock (Kp)=Dp/ (Pp - F)
	Dp= preferred dividend =price x yield rate = $94 x 7% =$6.58
	Pp= price = $94
	F= Floatation cost = $5
	cost of preferred stock (Kp)=Dp/ (Pp - F)
	cost of preferred stock (Kp)=$6.58/ (94-5)
	cost of preferred stock (Kp)=$6.58/$89
	cost of preferred stock (Kp)=0.073932584
	cost of preferred stock (Kp)=7.3932584%
	cost of preferred stock (Kp)=7.39%
c.	Cost of common equity = 14.93%
Working Notes:
	Using Gordon growth model : P0 = D1 / (Ke - g), where D1 =$5.50
	cost of equity (ke) = ??
	Po=current share price = $63 per share
	g= growth rate= 6.20 %
	P0 = D1/(Ke -g)
	Ke= D1/P0 + g
	Ke= $5.50/$63 + 6.20%
	Ke= 0.087301587 + 6.20%
	Ke= 8.73015873% + 6.20%
	Cost of equity (Ke) = 14.93015873%
	Cost of equity (Ke) = 14.93%
d.		Weighted Cost
	Debt (Kd)	2.52
	Preferred stock (Kp)	1.85
	Common equity (Ke)	4.48
	Weighted average cost of capital (Ka)	8.85
Working Notes:
	Weighted cost = weight in capital structure x its cost of capital
	long term Debt weight in capital structure (Wd) =45% = 0.45
	Preferred stock weight in capital structure (Wp)= 25% = 0.25
	Common stock weight in capital structure(We) = 30% = 0.30
		W	C	WC= W x C
		Weight	Cost	Weighted Cost
	Debt (Kd)	0.45	5.6095%	2.52
	Preferred stock (Kp)	0.25	7.3932584%	1.85
	Common equity (Ke)	0.30	14.93015873%	4.48
	Weighted average cost of capital (Ka)			8.85
Please feel free to ask if anything about above solution in comment section of the question.