Question

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%

jeff jeffy answered 2 years ago

Since the financial crisis of 2008, the world economy has grown steadily until March of this...

Since the financial crisis of 2008, the world economy has grown steadily until March of this year. I began this semester by noting that we were in an era of unprecedented prosperity, even though we faced serious problems of economic inequality and global warming. We are now in what I would call a policy-induced global depression causing negative growth and rising unemployment. The ten years of growth were also associated with increased globalization which began to reverse before this crisis...

Michelle O’Sullivan is a financial analyst at the Drill Corporation, a company who manufacture drilling equipment...

Michelle O’Sullivan is a financial analyst at the Drill Corporation, a company who manufacture drilling equipment used across the construction industry. Drill Corporation are doing some analysis around potentially tendering for a contract to supply the government with pneumatic drills used in road construction. The tender call requires the supply of 10,000 drills per year over a 10-year period. In the first round of analysis, Michelle assumes that each drill will be sold at a fixed price of $1,700 (which...

Michelangelo Shoes was founded by Buonarroti Simoni in 1996 and has grown steadily over the years....

Michelangelo Shoes was founded by Buonarroti Simoni in 1996 and has grown steadily over the years. Buonarroti Simoni now has 23 stores located throughout the Southern and Eastern parts of Australia. Buonarroti Simoni, born of migrant Italian parents, was an accounting major in college but loved high fashion shoes for men and women. He worked for a large regional CPA firm for 13 years prior to opening his first shoe store. He places a lot of value on internal controls....

2. You are the new financial analyst of the company ABC. Sales of ABC were $2,200,000...

2. You are the new financial analyst of the company ABC. Sales of ABC were $2,200,000 last year, variable costs were 50% of sales, and fixed costs were $220,000. Therefore, EBIT totaled $880,000. The EBIT is expected to be constant over time. Because no expansion capital is required, ABC pays out all earnings as dividends. Assets are $4 million, and 200,000 shares are outstanding. ABC currently has no debt it is an all equity firm and its 200,000 shares outstanding...

INTRODUCTION It was another sleepless night for Brian French. As a new father, French had grown...

INTRODUCTION It was another sleepless night for Brian French. As a new father, French had grown accustomed to sleep deprivation, but on this night, it was his business—not his newborn daughter—that had him tossing and turning. French was the president and co-owner of Peregrine, a Vancouver- based manufacturer of custom retail displays that were used in stores, banks, and art galleries (Exhibit 1). Peregrine had been working on a display for Best Buy when one of the company’s two computer-numerical-control...

Sales of? Volkswagen's popular Beetle have grown steadily at auto dealerships in Nevada during the past...

Sales of? Volkswagen's popular Beetle have grown steadily at auto dealerships in Nevada during the past 5 years? (see table below).?????????????????????????????????????????????????? Year Sales 1 455 2 502 3 516 4 555 5 590 ?a) Forecasted sales for year 6 using the trend projection? (linear regression) method are 620.5 sales ?(round your response to one decimal? place). b) What is the MAD? The MAD for a linear regression forecast is ______ sales ?(round your response to one decimal? place). c) What...

The GCC countries economies had been growing steadily over past years since the financial crisis of...

The GCC countries economies had been growing steadily over past years since the financial crisis of 2008 and their economies grew at 3,16% in 2016. a) how long will take to double their economic growth? b) explain what factors might influence Kuwait,s future rate of economic growth

The sales of Cool-Man air conditioners have grown steadily during the past six years as shown...

The sales of Cool-Man air conditioners have grown steadily during the past six years as shown on the table below. Year Sales 1 450 2 495 3 518 4 563 5 584 6 592 (a) Provide a forecast by using a 3-year weighted moving average technique with weights 4, 2, and 1 (4 = most recent). (b) Forecast sales using a 2-year moving average technique. (c ) What is the MSE from the 2-year moving average? Show work please

You are an analyst for a pipe manufacturing corporation that is considering a new project which...

You are an analyst for a pipe manufacturing corporation that is considering a new project which involves fabricating some custom pipe for a single customer. The project will take advantage of excess capacity in an existing plant. The plant has the capacity to produce 50,000 units of 18-inch pipe, but only 25,000 are being produced currently. Sales of 18-inch pipe are expected to increase by 10% a year. You want to use some of the remaining capacity to manufacture 20,000...

True Financial corporation is a financial services holding company headquartered in ithaca new york, that offers...

True Financial corporation is a financial services holding company headquartered in ithaca new york, that offers banking insurance and wealth management service. It pays cash dividends quarterly and also issues stock dividends periodically. 1. At March 31, 2012, True had 9,726,700 shares issued with a par value of $7.00 per share and $75,00 share held in treasury. On April 25, 2012, the company announced that its Board of Directors approved payment of a regular quarterly cash dividend of 3.50 per...