Calculation of individual costs and WACC- Dillon Labs has asked its financial ma

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: 45% long-term debt, 10% preferred stock, and 45% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 30%.

Debt- The firm can sell for $960 a 10-year, $1,000-par-value bond paying annual interest at a 9.00% coupon rate. A flotation cost of 4% of the par is required in addition to the discount of $40 per bond.

Preferred stock- 7.50% (annual dividend) preferred stock having a par value of $100 can be sold for $70. An additional fee of $4 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 (2016) is $3.01. Its dividend payments, which have been approximately 40% of earnings per share in the past 5 years, were shown in the following table:

It is expected that to attract buyers, new common stock must be underpriced $8 per share, and the firm must also pay $2.00 per share in flotation costs. Dividend payments are expected to continue at 40% of earnings. (Assume that rr=rs.) a. Calculate the after-tax cost of debt. b. Calculate the cost of preferred stock. c. Calculate the cost of common stock. d. Calculate the WACC for Dillon Labs.

a. The after-tax cost of debt using the bond’s yield to maturity (YTM) is________% (Round to two decimal places).

b. The cost of preferred stock is ________% (Round to two decimal places).

c. The cost of retained earnings is ________% (Round to two decimal places).

The cost of new common stock is ______% (Round to two decimal places).

d. Using the cost of retained earnings, the firm’s WACC is ______% (Round to two decimal places).

      Using the cost of new common stock, the firm’s WACC is ______% (Round to two decimal places).

Explanation / Answer

Solution:

a) Calculation of Cost of debt after tax

Cost of debt after tax = [Interest + (Redemption Value – Net Proceeds)/life] / (Redemption Value + Net Proceeds)/2 x (1 – Tax Rate)

Net Proceeds = Issue Price – Floatation Cost = $960 – ($1,000 x 4%) = $960 - $40 = $920

Interest amount = $1,000 x 9% = $90

Cost of debt after tax = [$90 + ($1,000 - $920)/10] / ($1,000 + $920)/2 x (1 – 0.30)

= ($90 - $8) / $960 x 0.70 = 0.05979 or 5.98%

b) Cost of Preferred Stock

Cost of preferred stock = Preference Dividend / Net Proceeds x 100 = $7.50 / ($70 - $4) x 100 = 11.36%

c) Cost of New common stock

Trend is showing 6.25% increase in earnings every year. Hence it is the growth rate.

Net Proceeds = $60 – 8 - $2 = $50

Cost of Equity = Next year expected dividend / Net Proceeds + growth rate

= $3.01 / $50 + 0.0625 = 0.1227 or 12.27%

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