Question

Wilma Brinton is a new financial analyst at Dorrington Corporation, a company that had grown steadily over the past 30 years and has now matured, being well known and highly respected.

Brinton’s first task is to explain the concept of weighted average cost of capital to new members of the Board of Directors.

Dorrington’s balance sheet is summarized below.

                         Assets                                                          Liabilities and net worth

Working capital              $200                        Bank loan                                                      $120

Plant and equipment         360                        Long-term debt                                                 80

Other assets                         40                        Preferred stock                                                100

                                                                        Common stock, incl. retained earnings          300

Total                               $600                        Total                                                             $600

Brinton also made the following notes:

Dorrington pays market interest rate (8%) on its bank loan. It has issued long-term bonds with a coupon of 7.75% and its market value is currently at par.

The preferred stock was originally issued at $100 per share, and now trades for $70 per share.

The common stock last traded for $40 per share. Next year’s earnings per share would be about $4, and dividends for share about $2. There are 10 million shares of common stock outstanding.

Earnings and dividends have grown steadily at 6.7% per year.

Dorrington currently pays taxes at a 35% rate.

Dorrington’s Beta has averaged 0.50 in the past 10 years. The interest rate on Treasuries is currently 7% and the market risk premium is 7%. Brinton intends to apply two methods for estimating the required return on equity.

While studying the figures, a colleague of Brinton’s interrupted and made the following suggestions:

Because Dorrington pays a dividend of $6 on preferred shares, the rate of return on preferred stock should be 6%. Is the colleague correct?

The colleague believes that Dorrington should easily be able to achieve a rate of return on equity of 16%. Is the colleague correct?

Write a memo estimating Dorrington’s weighted average cost of capital and explaining how you reached the result.

Answer 1

Preferred shares:

Face value per share=$100

Dividend per share=$6

Though the return of preferred share based on face value is 6%,It is not correct to say that the rate of return is 6%.

The rate of return should be calculated based on the market value which is $70 per share.

Hence the return per share would be equal to (6/70)*100 %=8.6%

Cost of preferred share=8.6%

Equity Shares:

Estimating Required return based on earning per share:

Next year’s dividend per share=$2

Growth rate of earning =6.7%

Current market price=$40

Required rate of Return=(2/40)+0.067=0.117=11.7%

Estimating Required Return based on CAPM Equation:

R=Rf+Beta*(Rm-Rf)

R=Required return of equity

Rf=Risk free rate=7%

Rm-Rf=Market risk premium=7%

Beta=0.5

Required return=7+0.5*7

Required return=7+3.5=10.5%

We should consider the cost of Equity , the higher value . to be conservative in project evaluation.

Hence cost of equity=11.7%

Cost of bank Loan=8*(1-Tax rate)=8*(1-0.35)=5.2%

Cost of long term bond=7.75*(1-0.35)=5.0%

CALCULATION OF WEIGHTED AVERAGE COST OF CAPITAL IS GIVEN BELOW:

	A	B=A/600	C	D=B*C
	Market value	Weight	Cost of capital(percent)	Weight*Cost
Bank Loan	$120	0.20	5.2	1.04
Long term Bond	$80	0.13	5.0	0.67
Preferred shares	$100	0.17	8.6	1.43
Common shares including retained earning	$300	0.50	11.7	5.85
Total capital	$600		SUM	8.99

Weighted Average Cost of capital=9%(Rounded)

Earning per share=$4

Total number of shares=10,000,000

Earning per share=$4*10000000=$40,000,000

Preferred dividend=$6*1000000=$6,000,000

Amount available for equity holders=(40-6)=$34 million

Return on equity=34/300=11.3%

The colleague’s believe that Dorrington should easily be able to achieve a rate of return on equity of 16%. Is NOT correct?

16% return =0.16*300million=$48 million Earning after preferred dividend

Which means total $54 million earning from current level of $40 million

Growth rate =6.7%

At this rate , it will take approximately 5 years to achieve earning of $54 million