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In: Finance

Wilma Brinton is a new financial analyst at Dorrington Corporation, a company that had grown steadily...

Wilma Brinton is a new financial analyst at Dorrington Corporation, a company that had grown steadily over the past 30 years and has now matured, being well known and highly respected. Brinton’s first task is to explain the concept of weighted average cost of capital to new members of the Board of Directors. Dorrington’s balance sheet is summarized below. Assets Liabilities and net worth Working capital $200 Bank loan $120 Plant and equipment 360 Long-term debt 80 Other assets 40 Preferred stock 100 Common stock, incl. retained earnings 300 Total $600 Total $600 Brinton also made the following notes: Dorrington pays market interest rate (8%) on its bank loan. It has issued long-term bonds with a coupon of 7.75% and its market value is currently at par. The preferred stock was originally issued at $100 per share, and now trades for $70 per share. The common stock last traded for $40 per share. Next year’s earnings per share would be about $4, and dividends for share about $2. There are 10 million shares of common stock outstanding. Earnings and dividends have grown steadily at 6.7% per year. Dorrington currently pays taxes at a 35% rate. Dorrington’s Beta has averaged 0.50 in the past 10 years. The interest rate on Treasuries is currently 7% and the market risk premium is 7%. Brinton intends to apply two methods for estimating the required return on equity. While studying the figures, a colleague of Brinton’s interrupted and made the following suggestions: Because Dorrington pays a dividend of $6 on preferred shares, the rate of return on preferred stock should be 6%. Is the colleague correct? The colleague believes that Dorrington should easily be able to achieve a rate of return on equity of 16%. Is the colleague correct? Write a memo estimating Dorrington’s weighted average cost of capital and explaining how you reached the result.

Expert Solution

In WACC calculation, cost of each source of capital is multiplied with its weighteage and sum of that multiplication is called weighted average cost of capital (WACC)

Cost of bank loan = Interest rate(1-t)

=8%(1-.35)

=8%(0.65)

=5.2%

Cost of debt = YTM(1-t)

YTM will be equal to the coupon rate as bond is trading at par

Cost of debt = 7.75%(1-0.35)

=7.75%(0.65)

=5.0375%

Cost of preference share = Dividend/ Face value

=6/100

=6%

Cost of equity as per CAMP

=Risk free rate + beta( Risk premium)

=7% + 0.5(7%)

=7%+3.5%

=10.5%

Cost of equity as per dividend discount model

=D1/Po + g

D1 = dividend of next year, Po = current market price and g = growth rate

=2/40 + 0.067

=0.05 + 0.067

=11.7%

Thus colleague is correct regarding cost of prefrence share but he is wrong with regards to cost of equity

Statement showing WACC ( Cost of equity as per CAPM)

Source	Amount	Weight	K	WACC =W*K
Bank loan	120	20.00%	5.20%	1.04%
Long-term debt	80	13.33%	5.04%	0.67%
Preferred stock	100	16.67%	6.00%	1.00%
Common stock, incl. retained earning	300	50.00%	10.50%	5.25%
	600			7.96%

Statement showing WACC ( Cost of equity as per Dividend discount model)

Source	Amount	Weight	K	WACC =W*K
Bank loan	120	20.00%	5.20%	1.04%
Long-term debt	80	13.33%	5.04%	0.67%
Preferred stock	100	16.67%	6.00%	1.00%
Common stock, incl. retained earning	300	50.00%	11.70%	5.85%
	600			8.56%

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