CALCULATION OF INDIVIDUAL COSTS AND WACC: Dillon has asked its financial manager
ID: 2772532 • Letter: C
Question
CALCULATION OF INDIVIDUAL COSTS AND WACC:
Dillon 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: 40% long-term debt, 10% preferred stock, and 50% common stock rquity (retained earnings,new common stock, or both). The firms tax rate is 40%.
Debt: The firm can sell for $980 a 10-year, $1000 par-vale bond paying annual interest at a 10% coupon rate. A flotation cost is 3% of the par value is required in addition to the discount of $20 per bond.
Preferred Stock: 8% (annual dividend) preferred stock having a par value of $100 can ge sold for $65. An additional fee of $2 per share must be paid to the underwriters.
Common Stock: The firms 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 in the following table.
Year Dividend
2015 $3.75
2014 3.50
2013 3.30
2012 3.15
2011 2.85
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 flotation costs. Dividends payments are expected to continue at 60% 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
Explanation / Answer
Answer:
Cost of debt:
The face value =$1,000
The issue price net of flotation cost = $980 - $1,000*3%= $950
Annual coupon = $1,000*10% = $100
Period = 10 years
YTM is the IRR of the cashflow = you can use the rate function to get the IRR = =RATE(10,100,-950,1000,0) = 10.84%
After tax cost of debt = 10.84%(1-0.4) = $6.504
B)
Cost of preferred stock = Coupon/(Market price - issue cost) = $8/($65-$2) = 12.7%
c) Growth rate = ROE*Rention ratio = ROE * (1--payout ratio)
Current EPS = $3.75/0.6 = $6.25, ROE = $6.25/$50 = 12.5%
Growth rate = 12.5%(1-0.6) = 5%
So the cost of equity = {Dividend/(share price-flotation cost - discount)} +growth rate = $4/($50-3-5) + 5%
= 14.52%
d)
Cost Weight Cost*weight Debt 6.50% 40% 2.60% Preference share 12.70% 10% 1.27% equity 14.52% 50% 7.26% WACC= 11.13%Related Questions
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