Question

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, 20​% preferred​ stock, and 35​% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 20​%.

Debt The firm can sell for $965 a 13​-year, $1,000​-par-value bond paying annual interest at a 7.00​% coupon rate. A flotation cost of 22​% of the par value is required in addition to the discount of $35 per bond.

Preferred stock 7.50​% ​(annual dividend) preferred stock having a par value of $100 can be sold for $75. An additional fee of $6 per share must be paid to the underwriters.

Common stock The​ firm's common stock is currently selling for $90 per share. The dividend expected to be paid at the end of the coming year​ (2016) is $3.77. Its dividend​ payments, which have been approximately 60​% of earnings per share in the past 5​ years, were as shown in the following​ table:

Year	Dividend
2015	3.54
2014	3.32
2013	3.12
2012	2.93
2011	2.75

It is expected that to attract​ buyers, new common stock must be underpriced $5 per​ share, and the firm must also pay $2.50 per share in flotation costs. Dividend payments are expected to continue at 60​% of earnings. ​ (Assume that r_r = r_s)

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.

Answer 1

a) Cost of debt can be calculated using I/Y function on a financial calculator

N = 13, PMT = 7% x 1000 = 70, PV = -(965 - 220) = -745, FV = 1000

=> Compute I/Y = 10.73% is the before-tax cost of debt

After tax cost of debt = 10.73% x (1 - 20%) = 8.58%

b) Cost of preferred debt = Dividend / (Price - Flotation) = 7.5 / (75 - 6) = 10.87%

c) Cost of common stock = D1 / (P - F) + g

where, D1 - next dividend, P - Price, F - Flotation, g - growth in dividends = (3.77 / 2.75)^(1/5) - 1 = 6.5%

r = 3.77 / (90 - 2.5 - 5) + 6.5% = 11.08%

d) WACC = wd x rd x (1 - tax) + wps x rps + we x re

= 45% x 8.58% + 20% x 10.87% + 35% x 11.08%

= 9.91%