Calculation of individual costs and WACC - Assume that today is December 31, 201

Question

Calculation of individual costs and WACC - Assume that today is December 31, 2012. 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, 10% preferred stock, and 40% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 30%.

Debt - The firm can sell for $980 a 14-year, $1,000-par-value bond paying annual interest at a 9% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond.

Preferred stock - 7%(annual dividend) preferred stock having a par value of $100 can be sold for $70. 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 dividend expected to be paid at the end of the coming year (2013) is $4.04. Its dividend payments, which have been approximately 40% of earnings per share in each of the past 5 years, were as shown in the following table.

It is expected that to attract buyers, new common stock must be underpriced $4 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 40% of earnings. (Assume that rr = rs.)

a. What is the after tax cost of debt using the bond's yield to maturity? What is the after-tax cost of debt using the approximation formula?

b. What is the cost of preferred stock?

c. What is the cost of retained earnings? What is the cost of new common stock?

d. Using the cost of retained earnings, what is the firm's WACC? Using the cost of new common stock, what is the firm's WACC?

Explanation / Answer

Cost of debt Net proceeds of the bond 1000-3%*1000- 20=    950 Before tax cost of debt is the cost(rate) that equates this value at 9% to the future interest payments + receipt of face value at maturity. so. We use the formula , to calculate PV and solve for r, PV=(Coupon amt.*((1-(1+r)^-n)/r))+(Face value/(1+r)^n) 950=(90*((1-(1+r)^-14)/r))+(1000/(1+r)^14) r= 9.67% (YTM) After tax cost of debt= 9.67(1-0.30)= 6.77% BT cost of Debt (Approximation Formula 90+ (1000-950)/14)/(1000+950)/2 9.60% After-tax cost= 9.60(1-0.30)= 6.72% Cost of Preferred stock is Annual dividend/ Price- underwriter fee 7/(70-2)= 10.29% Calculation of Dividend Growth Rate 2008 2.75 2009 2.97 8.00 2010 3.21 8.08 2011 3.46 7.79 2012 3.74 8.09 Total 31.96 Av. Growth rate 31.96/4 7.99 Cost of Retained Earnings (Next-year's dividend/Current market price )+ Av. Growth rate (4.04/60)+0.0799 0.147233333 ie. 14.72% Cost of new equity (Next yr's dividend/(Market price- Flotation costs))+ growth rate (4.04/(60-4)) +0.0799 0.152042857 ie. 15.20% WACC using Cost of Retained Earnings Type of capital Weight to Total Cost Wt* Cost Long-term Debt 0.5 0.0677 0.03385 Preferred stock 0.1 0.1029 0.01029 Retained Earnings 0.4 0.1472 0.05888 Total 1 0.10302                                           WACC using Cost of Retained Earnings   =           10.30% WACC using Cost of New Equity Type of capital Weight to Total Cost Wt* Cost Long-term Debt 0.5 0.0677 0.03385 Preferred stock 0.1 0.1029 0.01029 New equity 0.4 0.152 0.0608 Total 1 0.10494                                           WACC using Cost of New Equity   =           10.49%

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