Dillon labs has asked it\'s financial manager to measure the cost of each specif
ID: 2712356 • Letter: D
Question
Dillon labs has asked it's 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: 40% long term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firms tax rate is 40 %. The firm can sell its bonds for $980.00 a 10-year, 1000 par-value bond paying annual interest at a 10% coupon rate. A floatation cost of 3% of the par value is required in addition to the discount of $20 per bond. Eight percent (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. The firms common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2010) is $ 4. It's dividend payments , which have been approximately 60% of earnings per share in each of the past five years, are shown in table below.
It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in floatation costs. Dividend payments are expected to continue at 60% of earnings.
A. Calculate the specific cost of each source of financing. Assume that the required return of retained earnings is equal to that on common stock.
B. If earning available to common shareholders are expected to be $7 million what is the break point associated with the exhaustion of retained earnings?
C. Determine the weighted average cost of capital between zero and the break point calculated in part b.
D. Determine the weighted average cost of capital just beyond the break point calculated in part b
YEAR DIVIDEND 2009 $3.75 2008 $3.50 2007 $3.30 2006 $3.15 2005 $2.85Explanation / Answer
Answer (A)
Post-tax cost of debt = 6.51% (Pre-tax cost of debt = 10.85%)
Cost of Preferred stock = 12.70%
Cost of Equity & retained earnings = 16.62%
Answer (B)
Break point associated with retained earnings = $ 14 Million
Answer (C)
Weighted Average Cost of Capital between zero and breakpoint = 12.18%
Answer (D)
Weighted Average cost of capital beyond breakpoint = 12.18%
Cost of Preference Capital
Annual Dividend = 8%
Par value =$100
Annual Dividend = $8
Price at which it can be sold = $65
Fee payable to underwriters = $2 per share
Cost of Preferred stock rp = Dividend /(Price – Floatation cost)
rp = $8/ (65-2) = $8 /$63 = 0.12698 or 12.70% (rounded off)
Cost of Equity Capital
Expected Divided for 2010 = $4
Current Price = $50
Dividend for 2009 = $ 3.75
Dividend for 2005 = $2.85
Dividend growth rate = (Dividend for 2009/Dividend for 2005)^(1/4) - 1
= ($3.75/$2.85)^0.25 - 1 = 1.315789474^0.25 - 1
= 1.0710175 – 1 = 0.710175 or 7.10% (rounded off)
Underpricing of new equity stock = $5 per share
Floatation cost = $3 per share
Cost of equity = [Exp dividend in 2010/(current price – under pricing – floatation cost)]+growth rate
= [$4/(50-5-3)]+0.0710
= [$4/42] + 0.0710
= 0.095238 + 0.0710
re = 0.166238 or 16.62% (rounded off)
Calculation of Cost of Debt
Period of Bond = 10 years
Par value = 1000
Annual Coupon rate = 10%
Annual Coupon Payment = 1000 * 10% = $ 100
Floatation cost = 3% of par value
Floatation cost per bond = 1000 * 3% = $30
Price at which bond can be sold = 980
Net amount receivable per bond by company = Sell Price - floatation cost = $ 980 - $ 30 = $ 950
Let r be the rate return on the bond , then price of the bond can be calculated using
950 = 100 * [(1-(1/(1+r)^10))/r] + 1000 / (1+r)^10
950 - 100 * [(1-(1/(1+r)^10))/r] - 1000 / (1+r)^10 = 0
Let r = 10.5%, then LHS will be
= 950 – 100 * [(1-(1/(1.105)^10))/0.105] - 1000 / (1.105)^10
= 950 – 100 * [(1-(1/2.714081))/0.105] - 1000 / 2.714081
= 950 – 100 * [(1-0.368449))/0.105] – 1000 * 0.368449
= 950 – 100 * (0.631551/0.105) – 368.4489
= 950 – 100 * 6.014773 – 368.4489
= 950 – 601.4773 – 368.4489
= - 19.9261
Let r = 11%, the LHS will be
= 950 – 100 * [(1-(1/(1.11)^10))/0.11] - 1000 / (1.11)^10
= 950 – 100 * [(1-(1/(2.839421))/0.11] - 1000 / 2.839421
= 950 – 100 * (1-0.352184)/0.11 – 1000 * 0.352184
= 950 – 100 * (0.647816/0.11) – 352.1845
= 950 – 100 * 5.889232 – 352.1845
= 950 – 588.9232 – 352.1845
= 8.89232
Therefore r will be between 10.5% and 11%
r = 0.105 + [(-19.9261) * (0.105 – 0.11)]/(8.89232-(-19.9261)
r = 0.105 + (0.0996305 /28.81842)
= 0.105 + 0.003457
= 0.108457 or 10.85% (rounded off)
This 10.85% is the pre-tax cost of debt. At 40% tax rate the post tax cost of debt will be
Post tax cost of debt rd = pre-tax cost of debt * (1- tax rate)
= 10.85 * (1-0.40)
= 0.06507 or 6.51% (rounded off)
Amount of retained earnings available = $ 7 Million
Weight of common stock (incl retained earnings) = 50%
Break point of retained earnings = $ 7 Million / Weight of equty
= $ 7 Million / 0.50 = $ 14 Million
Weighted average cost of capital = 0.40 * 6.51% + 0.10 * 12.70% +0.50 * 16.62%
= 2.604% + 1.27% + 8.31%
= 12.184% or 12.18% (rounded off)
Weighted average cost of capital upto $ 14 Million would be 12.18%
Since rate of return required on Retained earnings is same as cost of new equity, the weighted average cost of capital beyond $ 14 Million also would be 12.18%
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