In: Finance
Northwest Utility Company faces increasing needs for capital.
Fortunately, it has an Aa3 credit rating. The corporate tax rate is
40 percent. Northwest’s treasurer is trying to determine the
corporation’s current weighted average cost of capital in order to
assess the profitability of capital budgeting projects.
Historically, the corporation’s earnings and dividends per share
have increased about 7.2 percent annually and this should continue
in the future. Northwest’s common stock is selling at $62 per
share, and the company will pay a $2.50 per share dividend
(D1).
The company’s $92 preferred stock has been yielding 5 percent in
the current market. Flotation costs for the company have been
estimated by its investment banker to be $4.00 for preferred
stock.
The company’s optimal capital structure is 30 percent debt, 20 percent preferred stock, and 50 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.
Data on Bond Issues | ||||||
Issue | Moody’s Rating |
Price | Yield to Maturity | |||
Utilities: | ||||||
Southwest electric power––7 1/4 2023 | Aa2 | $ | 885.18 | 8.54 | % | |
Pacific bell––7 3/8 2025 | Aa3 | 889.25 | 8.53 | |||
Pennsylvania power & light––8 1/2 2022 | A2 | 960.66 | 8.55 | |||
Industrials: | ||||||
Johnson & Johnson––6 3/4 2023 | Aaa | 860.24 | 8.34 | % | ||
Dillard’s Department Stores––7 3/8 2023 | A2 | 940.92 | 8.66 | |||
Marriott Corp.––10 2015 | B2 | 1,025.10 | 9.75 | |||
a. Compute the cost of debt,
Kd (use the accompanying table—relate to the
utility bond credit rating for yield.) (Do not round
intermediate calculations. Input your answer as a percent rounded
to 2 decimal places.)
b. Compute the cost of preferred stock,
Kp. (Do not round intermediate
calculations. Input your answer as a percent rounded to 2 decimal
places.)
c. Compute the cost of common equity in the
form of retained earnings, Ke. (Do not
round intermediate calculations. Input your answer as a percent
rounded to 2 decimal places.)
d. Calculate the weighted cost of each source
of capital and the weighted average cost of capital. (Do
not round intermediate calculations. Input your answers as a
percent rounded to 2 decimal places.)
a
Cost of debt = 8.53%
b
Yield = dividend/price
0.05 = dividend/92
dividend = 4.6
Proceeds from capital raise = price-flotation = 92-4 = 88
cost of preferred equity |
cost of preferred equity = Preferred dividend/price*100 |
cost of preferred equity = 4.6/88*100 |
=5.23 |
c
Cost of equity |
As per DDM |
Price = Dividend in 1 year/(cost of equity - growth rate) |
62 = 2.5/ (Cost of equity - 0.072) |
Cost of equity% = 11.23 |
d
Weight of equity = E/A |
Weight of equity = |
W(E)=0.5 |
Weight of debt = D/A |
Weight of debt = 0.3 |
W(D)=0.3 |
Weight of preferred equity =1-D/A-E/A |
Weight of preferred equity = =1-0.3 - 0.5 |
W(PE)=0.2 |
After tax cost of debt = cost of debt*(1-tax rate) |
After tax cost of debt = 8.53*(1-0.4) |
= 5.118 |
WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE) |
WACC=5.12*0.3+11.23*0.5+5.23*0.2 |
WACC =8.2% |