Question

Principles of Managerial Finance (14th Edition)

Chapter 9, Problem 17P

An example in Spreadsheet format.

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

35 %.

Debt The firm can sell for

$970

a

17 -year,

$1, 000 -par-value

bond paying annual interest at a

11.00 %

coupon rate. A flotation cost of

4 %

of the par value is required in addition to the discount of

$30

per bond.

Preferred stock 10.00 %

(annual dividend) preferred stock having a par value of

$100

can be sold for

$85.

An additional fee of

$6

per share must be paid to the underwriters.

Common stock The firm's common stock is currently selling for

$50

per share. The dividend expected to be paid at the end of the coming year (2016) is

$2.87.

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   $2.67
2014   $2.48
2013   $2.31
2012   $2.15
2011   $2.00

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.

It is expected that to attract buyers, new common stock must be underpriced

$5

per share, and the firm must also pay

$2.00

per share in flotation costs. Dividend payments are expected to continue at

50 %

of earnings.

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

The formula for WACC is given as:

WACC = r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)

Where, r(E), r(P) and r(D) are cost of equity, preferred stock and cost of debt, w(E), w(P) and W(D)

are weight of equity, preferred stock and debt and t is the tax rate

Cost of debt will be the yield to maturity of the bond.

Cost of preferred stock will be dividends paid to preferred stock dividends by net proceed.

Cost of equity can be calculated using dividend growth model.