Question

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 30 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 5.3 percent annually and this should continue in the future. Northwest’s common stock is selling at $77 per share, and the company will pay a $4.30 per share dividend (D1). The company’s $122 preferred stock has been yielding 6 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 optimum capital structure is 45 percent debt, 10 percent preferred stock, and 45 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 $ 960.18 8.34 % Pacific bell––7 3/8 2025 Aa3 904.25 8.23 Pennsylvania power & light––8 1/2 2022 A2 990.66 8.99 Industrials: Johnson & Johnson––6 3/4 2023 Aaa 840.24 8.44 % Dillard’s Department Stores––7 1/8 2023 A2 990.92 8.55 Marriott Corp.––10 2015 B2 1,100.10 9.77 a. Compute the cost of debt, Kd. (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, Kp. (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, Ke. (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

Part (a)

Pre tax Cost of debt = Yield of Aa3 credit rated bond = YTM of Pacific Bell = 8.23%

Post tax cost of debt, Kd = Pre tax cost x (1 - tax ratge) = 8.23% x (1 - 30%) = 5.76%

Part (b)

The company’s $122 preferred stock has been yielding 6 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $5.00 for preferred stock.

Hence, cost of preferred stock, Kp = annual dividend / (Price - flotation cost) = 122 x 6% / (122 - 5) = 6.26%

Part (c)

Cost of common equity in the form of retained earnings, Ke = D1 / P0 + g = 4.3/77 + 5.3% = 10.88%

Part (d)

The company’s optimum capital structure is 45 percent debt, 10 percent preferred stock, and 45 percent common equity in the form of retained earnings.

Please see the table below. Please see the second row / column to understand the mathematics. The cells colored in yellow contain your answer.

Source	Weights	Cost	Weighted cost
	W	K	W x K
Debt	45%	5.76%	2.59%
Preferred	10%	6.26%	0.63%
Retained earnings	45%	10.88%	4.90%
		WACC =	8.12%