Question

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, 25​% preferred​ stock, and 45​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 28​%. Debt The firm can sell for ​$1,015 a 17​-year, ​$1,000​-par-value bond paying annual interest at a 9.00​% coupon rate. A flotation cost of 2​% of the par value is required. Preferred stock  8.50​% ​(annual dividend) preferred stock having a par value of ​$100 can be sold for ​$92. An additional fee of ​$6 per share must be paid to the underwriters. Common stock  The​ firm's common stock is currently selling for ​$59.43 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from ​$2.00 ten years ago to the ​$3.93 dividend​ payment, Upper D 0​, 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 ​$3.00 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)
FV = 1000
PMT = 1000 * 9% = 90
Nper = 17
PV = 1015 - (1000 * 2%) = 995

After tax cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)*(1-Tax rate)
=RATE(17,90,-995,1000)*(1-0.28)
= 6.52%

After tax cost of debt = 6.52%

b)

Annual dividend = 100 * 8.50% = $8.50

Cost of preferred stock = Annual dividend / (Share value - floatation cost)
= $8.50 / ($92 - $6)
= $8.50 / $86
= 9.88%

Cost of preferred stock = 9.88%

c)
Dividend year 1 = $2
Dividend year 10 = $3.93

Growth rate can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(10,0,-2,3.93)
= 6.99%

Next year dividend = $3.93 * (1 + 6.99%) = $4.20

Cost of common stock = Next year dividend / (Share value - costs) + growth rate
= $4.20 / ($59.43 - $3 - $3) + 6.99%
= $4.20 / $53.43 + 6.99%
= 7.87% + 6.99%
= 14.86%

Cost of common stock = 14.86%

Cost of retained earnings = Next year dividend / Share value + growth rate
= $4.20 / 59.43 + 6.99%
= 14.06%

Cost of retained earnings = 14.06%

Average cost of equity = (14.86% + 14.06%) / 2 = 14.46%

d)
WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (Weight of common stock * cost of common stock)
= (30% * 6.52%) + (25% * 9.88%) + (45% * 14.46%)
= 10.93%

WACC = 10.93%