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

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: 40% long-term debt 15% preferred stock, and 45% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 40% Debt The firm can sell for $970 a 20-year, $1,000-par-value bond paying annual interest at a 12.00% coupon rate. A flotation cost of 2% of the par value is required in addition to the discount of $30 per bond. Preferred stock 7.00% (annual dividend) preferred stock having a par value of $100 can be sold for $85. An additional fee of $4 per share must be paid to the underwriters. Common stock The firm's common stock is currently selling for $80 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 50% of earnings per share in the past 5 years, were as shown in the following table: It is expected that to attract buyers, new common stock must be underpriced $6 per share, and the firm must also pay $2.50 per share in flotation costs. Dividend payments are expected to continue at 50% of earnings. (Assume that r

Explanation / Answer

After tax cost of debt 970-20=120*(PVIF,r%,20)+1000*(PVIF,r%,20) r=12.7% Cost of debt after tax =12.7%*(1-.4) Cost of Debt after tax =7.62% Working Note: 12.70% Year Inflow Disc. Fact Dis.Cash flow 1 120 0.88731145            106 2 120 0.7873216               94 3 120 0.69859947               84 4 120 0.61987531               74 5 120 0.55002245               66 6 120 0.48804122               59 7 120 0.43304456               52 8 120 0.3842454               46 9 120 0.34094534               41 10 120 0.3025247               36 11 120 0.26843363               32 12 120 0.23818423               29 13 120 0.2113436               25 14 120 0.18752759               23 15 120 0.16639538               20 16 120 0.14764452               18 17 120 0.13100668               16 18 120 0.11624372               14 19 120 0.10314439               12 20 1120 0.09152119            103 Present Value            950 Cost of Preferred Stock D=7 P0=85 Flotation cost=4 Kp=d/(P0-F) Kp=7/(85-4) 8.64% Cos of equity Ke=D1/P0-Issuing cost D1=3.01 P0=80 Issuing Cost=6+2.5=8.5 Ke=3.01/(80-8.5) 4.21% WACC=Wd*Rd+Wp*Rp+We*Re =40%*7.62%+15%*8.64%+45%*4.21% 6.24%

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