Calculation of individual costa and WACC DIllion labs has asked its financial ma

Question

Calculation of individual costa and WACC DIllion 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 cost is to be measured by using the following weights: 40% long term debt, 10% preferred, and 50% common stock equity (retained earnings, new common stock or both). The firm's tax rate is 40%

DEBT the firm can see $980 a 10-year, $1000 par value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is requireed in adition to the discount of $20 per bond.

PREFERRED STOCCk 8% (annual dividend) preferred stock having a par value of $100 can be sold for $65. AN additional fee of $2 per share must be paid to the underwriters.

COMMON STOCK The firm's common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2016) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown

2015 $3.75
2014 $3.50

2013 $3.30

2012 $3.15

2011 $2.85

It is expected to attract buyers, new common stock must be underpriced $5 per share, and the firm must pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings.

a. calculate the after tax debt

b. calculate the cost of preferred stock

c. calculate the cost of common stock

d. calculate the WACC for Dillion Labs.

Explanation / Answer

Answer:

Calculations as required;

a. The after tax cost of Debt Fund;

Par Value of Bond is $ 1,000, Issue Value of Bond is $ 980, Discount on issue is $ 20, Floating Cost is $ 3.00, Coupon Rate is 10%, period is 10 years and Tax Rate is 40%;

therefore, after tax cost of debt = Discount on issue + Floating Cost + Annual Coupon Payment (1 - Tax Rate)

After Tax Cost of Debt = $ 20 + $ 3 + $ 100 (1-0.40) = $ 83 per bond issued.

b. The Cost of Preferred Stock;

Face Value is $ 100, Issue Value is $ 65, Distount is $ 35, Underwriters Commission is $ 2 per share and annual dividend rate is 8%;

Cost of Preferred Stock = Discount on issue + Underwriters Commission + Annual Preferred Dividend

Cost of Preferred Stock = $ 35 + $ 2 + $ 8 = $ 45 per preferred stock issued

c. The Cost of Common Stock

i. Cost of existing Common Stock = Expected Dividend = $ 4 per existing common share

ii. For new common stock; Current Market Price is $ 50 per share, Discount on fresh issue is $ 5 per share, Fresh Issue Price is $ 45 per share, Floating Cost is $ 3 per share, Dividend is 60% of earnings and average dividend is $ 3.31 per share {($ 3.75 + $ 3.50 + $ 3.30 + $ 3.15 + $ 3.85) / 5};

Cost of new Common Stock = Discount on issue + Floating Cost + Expected Dividend

Cost of new Common Stock = $ 5 + $ 3 + $ 3.31 = $ 11.31 per share

Note: Since dividend payout is $ 3.31 which is 60% of earnings, therefore Retained Earnings is $ 3.31 x 0.40 / 0.60 = $ 2.20 and its cost shall be the saving in tax to individual investors. In absence of any information it is assumed 40% as equal to tax rate that is 40% of $ 2.20 = $ 0.88.

d. The WACC for Dillion Labs

In absence of any information about number of Bonds, Preferrence Shares, Existing Common Shares and New Common Shares; the WACC is calculated by assuminf only one unit of each;

WACC = 40% of cost long term debt + 10% of cost of Preferred Stock + 50% of (cost of Common Stock + cost of Retained Earnings)

WACC = 40% of ($ 83) + 10% of ($ 45) + 50% of ($ 11.31 + $ 0.88) = $ 43.795.

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