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: 45% long-term debt,15​% preferred​ stock, and 40​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 28%.

Debt The firm can sell for $1005 a 12-year, $1,000 ​-par-value bond paying annual interest at a 11.00% coupon rate. A flotation cost of 2.5% of the par value is required.

Preferred stock 7.50% (annual dividend) preferred stock having a par value of $100 can be sold for $92. An additional fee of $33 per share must be paid to the underwriters.

Common stock The​ firm's common stock is currently selling for $60 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from $2.75 ten years ago to the $5.16 dividend​ payment, Upper D0​, that the company just recently made. If the company wants to issue new new common​ stock, it will sell them $3.00 below the current market price to attract​ investors, and the company will pay $4.00 per share in flotation costs.

a. The​ after-tax cost of debt using the​ bond's yield to maturity​ (YTM) is

(Round to two decimal​ places.)

The​ after-tax cost of debt using the approximation formula is

(Round to two decimal​ places.)

b.The cost of preferred stock is

(Round to two decimal​ places.)

c.The cost of retained earnings is

(Round to two decimal​ places.)

The cost of new common stock is

(Round to two decimal​ places.)

d.Using the cost of retained​ earnings, the​ firm's WACC is

(Round to two decimal​ places.)

Using the cost of new common​ stock, the​ firm's WACC is

(Round to two decimal​ places.)

Answer 1

a)
Calculation of after-tax cost of debt using the​ bond's yield to maturity​:

PV = 1005 - (1000 * 2.5%) = 980
FV = 1000
Nper = 12
PMT = 1000 * 11% = 110

Before tax cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(12,110,-980,1000)
= 11.31%

After tax cost of debt = Before tax cost of debt * (1 - t)
= 11.31% * (1 - 0.28)
= 8.15%

After tax cost of debt = 8.15%

Calculation of after-tax cost of debt using approximation formula:

Before tax cost of debt = (Coupon payment + (FV - PV) / N) / ((PV + FV) / 2)

= ($110 + ($1000 - $980) / 12) / (($980 + $1000) / 2)

= $111.6667 / $990

= 11.28%

After tax cost of debt = 11.28% * (1 - 0.28) = 8.12%

After tax cost of debt = 8.12%

b)
Cost of preferred stock = Annual dividend / (current price - fee)
= $7.50 / ($92 - $33)
= $7.50 / $59
= 12.71%

Cost of preferred stock = 12.71%

c)
Growth rate can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(10,0,-2.75,5.16)
= 6.50%

D1 = $5.16 * (1 + 6.50%) = $5.50

Cost of retained earnings = D1 / P0 + g
= ($5.50 / $60) + 0.0650
= 0.0916 + 0.0650
= 15.65%

Cost of retained earnings = 15.65%

Cost of new common stock = D1/ (P0 - costs) + g
= ($5.50 / ($60 - $3 - $4) + 0.0650
= 0.1037 + 0.0650
= 16.86%

Cost of new common stock = 16.86%

d)
WACC using cost of retained earnings = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of retained earnings * cost of retained earnings)

= (45% * 8.15%) + (15% * 12.71%) + (40% * 15.65%)

= 11.83%

WACC using cost of retained earnings = 11.83%

WACC using cost of new common stock = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of new common stock * cost of new common stock)

= (45% * 8.15%) + (15% * 12.71%) + (40% * 16.86%)

= 12.32%

WACC using cost of new common stock = 12.32%