Question

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: 40?% long-term debt, 15?%

preferred? stock, and 45?% common stock equity? (retained earnings, new common? stock, or? both). The?firm's tax rate is 40?%.

Debt: The firm can sell for $950 a 11?-year, $1,000?-par-value bond paying annual interest at a 12.00?%

coupon rate. A flotation cost of 2.5?% of the par value is required in addition to the discount of $50 per bond.

Preferred stock: 8.00?% (annual dividend) preferred stock having a par value of $100 can be sold for $80.

An additional fee of $22 per share must be paid to the underwriters.

Common stock: The? firm's common stock is currently selling for $70 per share. The dividend expected to be paid at the end of the coming year? (2016) is $3.68. Its dividend? payments, which have been approximately 50?% of earnings per share in the past 5? years, were as shown in the following? table:

2015	$3.47
2014	$3.28
2013	$3.09
2012	$2.92
2011	$2.75

It is expected that to attract? buyers, new common stock must be underpriced $44 per? share, and the firm must also pay $2.50 per share in flotation costs. Dividend payments are expected to continue at 50?% of earnings. ?

(Assume that rr? = rs?)   [Round to two decimal places]

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

A. Cost of Debt or KD = [Interest(1-tax rate)+{(Maturity Value-Net Proceeds)/n}]/(Maturity Value+Net proceeds)/2

=[1000*12%(1-40%)+{(1000-925)/11}]/(1000+950)/2

=[72+(75/11)]/975

Cost of Debt or KD=8.08%

Working Note-

Note- It is assumed that In $950 discount of Rs. $50 is included.

Net proceeds = Face value - Discount - Flotation cost

=$950 - $1000*2.5%

=$925.

B. Cost Of Preferred stock or KP = (Dividend / Net Proceeds)*100

= [(100*8%)/$58]*100

Cost Of Preferred stock or KP= 13.79%

Working Note-

Net Proceeds = Sell value - any commision

= $80-$22

=$58.

C. Firstly we need to calculate Growth rate-

DPS_{latest Year} = DPS_{Base Year} *(1+g)^n-1

$3.68 = $2.75*(1+g)^6-1

$3.68/$2.75 = (1+g)⁵

G = 6%

C. Cost of Common Stock or KE =( DPS/P₀)+G

= ($3.68/$41.5)+6

Cost of Common Stock or KE = 14.87%

Working Note-

P₀ = $44-$2.5

= $41.5

D. WACC

Particular	Weight	Cost	WACC
Debt	0.4	8.08	3.232
Preference Share	0.15	13.79	2.0685
Equity share	0.45	14.87	6.6915
	WACC		11.992%