Question

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 30 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

Historically, the corporation’s earnings and dividends per share have increased about 7.6 percent annually and this should continue in the future. Northwest’s common stock is selling at $68 per share, and the company will pay a $5.20 per share dividend (D₁).

The company’s $104 preferred stock has been yielding 5 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $2.00 for preferred stock.

The company’s optimum capital structure is 30 percent debt, 25 percent preferred stock, and 45 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.

   

Data on Bond Issues
Issue	Moody’s Rating		Price	Yield to Maturity
Utilities:
Southwest electric power––7 1/4 2023	Aa2	$	915.18		8.55	%
Pacific bell––7 3/8 2025	Aa3		895.25		8.33
Pennsylvania power & light––8 1/2 2022	A2		990.66		8.66
Industrials:
Johnson & Johnson––6 3/4 2023	Aaa		840.24		8.56	%
Dillard’s Department Stores––7 1/8 2023	A2		1,000.92		8.77
Marriott Corp.––10 2015	B2		1,055.10		9.33

a. Compute the cost of debt, K_d. (Use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

b. Compute the cost of preferred stock, K_p. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

c. Compute the cost of common equity in the form of retained earnings, K_e. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

d. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  

Answer 1

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Solution

a). Northwest Utility has a credit rating of Aa3. The only other company having the same credit rating is Pacific Bell which has a yield of 8.33%. So yield for Northwest Utility bonds will be 8.33%.

kd = 8.33%*(1-Tax rate) = 8.33%*(1-30%) = 5.83%

b). Cost of preferred stock (kp) = annual dividend/(price - flotation cost)

kp = (5%*104)/(104-2) = 5.10%

c). Cost of retained earnings (ke) = (D1/P0) + growth rate

= (5.2/68) + 7.6% = 15.25%

d). Weighted cost of debt = weight of debt*kd = 30%*5.83% = 1.75%

Weighted cost of preferred stock = weight of preferred stock*kp = 25%*5.10% = 1.27%

Weighted cost of common equity = weight of common equity*ke = 45%*15.25% = 6.86%

Weighted average cost of capital = 1.75% + 1.27% + 6.86% = 9.88%