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 27​%.

Debt The firm can sell for ​$1005 a 11​-year, ​$1,000​-par-value bond paying annual interest at a 9.00​% coupon rate. A flotation cost of 3.5​% of the par value is required.

Preferred stock 8.00​% ​(annual dividend) preferred stock having a par value of ​$100 can be sold for ​$92. An additional fee of ​$3 per share must be paid to the underwriters.

Common stock The​ firm's common stock is currently selling for ​$70 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from ​$2.00 ten years ago to the ​$3.26 dividend​ payment, Upper D 0 D0​, that the company just recently made. If the company wants to issue new new common​ stock, it will sell them ​$3.50 below the current market price to attract​ investors, and the company will pay ​$2.50 per share in flotation costs.  

a.  Calculate the​ after-tax cost of debt.

b.  Calculate the cost of preferred stock.

c.  Calculate the cost of common stock​ (both retained earnings and new common​ stock).

d.  Calculate the WACC for Dillon Labs.

Answer 1

a]

after tax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 11 (11 years to maturity with 1 annual coupon payment each year)

pmt = 1000 * 9% (annual coupon payment = face value * annual coupon rate. This is a positive figure as it is an inflow to the bondholder)

pv = -969.83 (Net proceeds per bond = selling price - flotation cost = $1,005 - ($1,005 * 3.5%) = $. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 9.45%. This is the YTM.

after tax cost of debt = YTM of bond * (1 - tax rate)

after tax cost of debt = 9.45% * (1 - 27%)

after tax cost of debt = 6.90%

b]

cost of preferred stock = (annual dividend / net proceeds per share)

annual dividend = face value * dividend rate = $100 * 8% = $8

net proceeds per share = selling price of share - flotation cost

net proceeds per share = $92 - $3 = $89

cost of preferred stock = $8 / $89 = 8.99%

c]

Cost of retained earnings

cost of retained earnings = (next year dividend / current share price) + growth rate

dividend today = dividend 10 years ago * (1 + growth rate)¹⁰

$3.26 = $2.00 * (1 + growth rate)¹⁰

growth rate = ($3.26 / $2.00)^1/10 - 1

growth rate = 5.01%

next year dividend = last dividend * (1 + growth rate)

next year dividend = $3.26 * (1 + 5.01%) = $3.4232

cost of retained earnings = (next year dividend / current share price) + growth rate

cost of retained earnings = ($3.4232 / $70) + 5.01%

cost of retained earnings = 9.90%

Cost of new common stock

cost of new common stock = (next year dividend / net proceeds per share) + growth rate

net proceeds per share = current share price - discount - flotation costs

net proceeds per share = $70 - $3.50 - $2.50 = $64

cost of new common stock = ($3.4232 / $64) + 5.01%

cost of new common stock = 10.36%

d]

WACC = (weight of debt * after tax cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

WACC (using cost of retained earnings) = (40% * 6.90%) + (15% * 8.99%) + (45% * 9.90%)

WACC (using cost of retained earnings) = 8.56%

WACC (using cost of new common stock) = (40% * 6.90%) + (15% * 8.99%) + (45% * 10.36%)

WACC (using cost of new common stock) = 8.77%