Heavy Duty Zippers Inc., a manufacturer of girdles and other fine intimate appar

Question

Heavy Duty Zippers Inc., a manufacturer of girdles and other fine intimate apparel products, wants to determine its WACC today 6/15/2009. The firm issued 5000 bonds that mature in 20 years with $1,000 face value. These bonds pay an 8% coupon rate semiannually and are currently selling for $908. The firm has 50K preferred shares of stock outstanding with a book value of $30, but currently selling for $40 per share. The last (paid yesterday) preferred and common dividend payments were $3 and $1.5 per share respectively. The firm's EPS five years ago was $4 and the firm expects to increase its next dividend payment by the implied 5-year EPS growth rate. Flotation costs on debt and preferred equity (D&P) are both 1%, but 5% of the selling price in the case of common stocks. The common stock is selling today for $35 and the firm's tax rate and payout ratio are 35% and 30%. The firm has 80K shares of common stock outstanding with the same book value as that of its preferred stock. a) Calculate the book value and market value weights for each source of capital. b) Calculate the component costs of capital (Including flotation costs) for common equity, preferred equity, and debt. c) Determine the weighted average costs of capital using both the market and the book value weights.

Explanation / Answer

Heavy Duty Zippers a) Calculation of Book value weights for each source of capital Book Value(A) Number outstanding (B) Weights=A*B Common stock 30 80000 2400000 Preferred stock 30 50000 1500000 8% Bonds 1000 5000 5000000 Total 8900000 Calculation of Market value weights for each source of capital Market Value(A) Number outstanding (B) Weights=A*B Common stock 35 80000 2800000 Preferred stock 30 50000 1500000 8% Bonds 908 5000 4540000 Total 8840000 b) Calculation of component cost of capital including floatation costs Component cost of common stock 1.875 Working Notes Implied five years EPS growth rate is Dividend paid on common stock 1.5 Dividend Payout ratio 30% EPS =1.5/30% = 5 EPS five years ago 4 difference 1 Implied five years EPS growth rate is =1/4% 25 Next dividend to be higher by 25% so =1.5+25% of 1.5 Component cost of common stock 1.875 Market price per share 35 Cost of common stock =1.875/(35-(5%*35)) 5.64 Component cost Preferred stock 3.75 Working Notes Next dividend of preffered stock has to be higher by 25% Component cost Preferred stock =3+25% of 3 3.75 Market price per share 40 Cost of preferred stock =3.75/(40-(30*1%)) 9.45 Component cost of Bonds 52.5 Working Notes Yearly Interest on Bonds =1000*8% 80 Less : Tax @35% 28 52 Add : Flotation cost =10/20 years 0.5 Effective cost of Bonds 52.5 Market price of Bonds 908 Cost of Bonds =52.5/(908-(1000*1%))            = 5.85 Weighted average cost of capital using book Value Cost of capital Book Value weight weighted average cost of capital Common stock 5.64 2400000 =5.64*2400000/8900000 1.52 Preferred stock 9.45 1500000 =9.45*1500000/8900000 1.59 8% Bonds 5.85 5000000 =5.85*5000000/8900000 3.28 8900000 6.40 Weighted average cost of capital using Market Value Cost of capital Market Value weight Calculation same as above weighted average cost of capital Common stock 5.64 2800000 1.79 Preferred stock 9.45 1500000 1.60 8% Bonds 5.85 4540000 3.00 8840000 6.39

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