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:

30% ​long-term debt,

15% preferred​ stock, and

55% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 29%.

Debt The firm can sell for ​$1030 a 20​-year,

1,000​-par-value bond paying annual interest at a 6.00% coupon rate. A flotation cost of 4​% of the par value is required.

Preferred stock  

10.00​% ​(annual dividend) preferred stock having a par value of

​$100 can be sold for ​$96.

An additional fee of ​$6 per share must be paid to the underwriters.

Common stock  

The​ firm's common stock is currently selling for ​$80 per share.

The stock has paid a dividend that has gradually increased for many​ years, rising from ​$2.50

ten years ago to the ​$4.48 dividend payment that the company just recently made. If the company wants to issue new new common​ stock, it will sell them

​$2.50 below the current market price to attract​ investors, and the company will pay ​$3.50 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

Answer (a):

Price = $1030

Par value = $1000

Annual interest = 1000 * 6% = $60

Flotation cost = 4​% of the par value = 1000 * 4% = $40

Net proceeds = 1030 - 40 = $990

Time to maturity =20 years

Hence, before tax cost of debt:

= RATE (nper, pmt, pv, fv, type)

= RATE (20, 60, 990, 1000, 0)

= 6.08781%

After-tax cost of debt = before tax cost of debt * (1 - Tax rate) = 6.08781% * (1 - 29%) = 4.3223%

After-tax cost of debt = 4.32%

Answer (b):

Preferred stock:

Par value = $100

Dividend = 100 * 10% = $10

Sale price = $96

Underwriter additional fee = ​$6

Net Realization = 96 - 6 = $90

Cost of preferred stock =10 / 90 = 11.1111%

Cost of preferred stock = 11.11%

Answer (c):

Dividend growth rate = =((End Value/Start Value)^(1/Periods) -1.= (4.48 / 2.50) ^(1/10) -1 = 6.01%

Sale price = $80

Amount realizable = 80 - 2.50 - 3.50 = $74

Cost of equity = D1/P0 + g = (4.48 * (1 + 6.01%) / 74) + 6.01% = 12.4245%

Cost of equity = 12.42%

Answer (d):

WACC = Cost of equity * Equity % + Cost of preferred stock * preferred stock % + after tax cost of debt * Debt %

=12.4245% * 55% + 11.1111% * 15% + 4.3223% * 30%

= 9.80%

WACC = 9.80%