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:50​% long-term debt, 20% preferred​ stock, and 30% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 28​%.

Debt: The firm can sell for ​$1010 a 12​-year, ​$1000​-par-value bond paying annual interest at a 8.00​% coupon rate. A flotation cost of 2​% of the par value is required.

Preferred stock: 8.00% ​(annual dividend) preferred stock having a par value of $100 can be sold for $98. An additional fee of ​$2 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 $2.70 ten years ago to the $4.00 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 ​$3.50below 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

				Face Value	1000
(I)		Year	Coupon	Coupon Rate	8%
	FV*CR	1	80	Market Price	1010
	FV*CR	2	80	Flotation Cost	2%
	FV*CR	3	80	Adjusted Market Price	989.8	Market Price * ( 1 - Flotation Cost)
	FV*CR	4	80	Tax Rate	28%
	FV*CR	5	80	Let Rd be the cost of debt
	FV*CR	6	80	So now discounting the Coupon payments with Rd should be equal to the Adjusted Market price
	FV*CR	7	80	Using Financial Calculator Put the following Values and Calcluate Rd
	FV*CR	8	80	N = 12
	FV*CR	9	80	PMT = 80
	FV*CR	10	80	PV= -989.8
	FV*CR	11	80	FV=1000
	FV*CR	12	80	I/Y = ?	This will give you before Tax cost of debt
				So I/Y = 8.13 %	Before tax
			Kd   =	5.86%	After Tax Cost of debt   8.13 ( 1 - 28%)
(II)		Annual Dividend		8%	(Given)
		Face value		100	(Given)
		Market price		98	(Given)
		Flotation cost		2	(Given)
		Adjusted Market price		96		market Price - Floatation cost
		Dividend		8		Face Value * Annual Dividend
			Kps =	Dividend /   Adjusted market price		= 8 / 96 *100	= 8.33%
(III)		Current market price		60	(Given)
		Dividend (10 years ago)		2.7	(Given)
		Dividend (Now)		4	(Given)
		flotation Cost		2.5	(Given)
		Discount of Market Price		3.5	(Given)
		Adjusted Market price for Retained Earnings		57.5	Market Price - Flotation cost
		Adjusted Market price for New Stock		54	Market Price - Discount on Market Price - Flotation cost
		Growth   (Dividend CAGR for 10 years)		[( End Value / Start value)^ 1/n] - 1
		Growth   (Dividend CAGR for 10 years)		4.008	{[ ( 4/2.7) ^0.1 ] -1 } *100
		D0 (current Dividend)		4	(Given)
		D1 (next year)		4.16032	D0 * ( 1 + growth)
		Ke        (formula) =	(   D1 / Price )   + Growth
		Ke     (Retained earnings)   =	0.11243	or 11.243%	(   D1 / Adjud. Market Price for Ret. Earning )   + Growth
		Ke     (New Stock)   =	0.11712	or 11.712%	(   D1 / Adjud. Market Price for New Stock )   + Growth
(IV)	Weight	Debt	50%	After Tax Cost of Debt	5.86%
	Weight	Preferred Stock	20%	Cost of Preferred Stock	8.33%
	Weight	Common Stock	30%	Cost of Common Stock Retained growth	11.24%
	WACC =	Weight Of debt * After tax cost Of debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight Of Equity * cost of Equity
	WACC =	0.5 * 5.86% +   0.2 * 8.33% + 0.3 * 11.24%
	WACC =	7.962		(Using Retained Earning Cost of Equity