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:

50% ​long-term debt, 15% preferred​ stock, and 35% common stock equity​ (retained earnings, new common​ stock, or​ both). The​ firm's tax rate is 29%.

Debt The firm can sell for ​$1015 a 13​-year, $1,000​-par-value bond paying annual interest at a 7.00%   coupon rate. A flotation cost of 4​% of the par value is required.

Preferred stock 10.00​% ​(annual dividend) preferred stock having a par value of ​$100 can be sold for $92. An additional fee of ​$4 per share must be paid to the underwriters.

Common stock The​ firm's common stock is currently selling for ​$50 per share. The stock has paid a dividend that has gradually increased for many​ years, rising from ​$3.00 ten years ago to the ​$4.89 dividend​ payment, Upper D 0​, that the company just recently made. If the company wants to issue new new common​ stock, it will sell them $2.00 below the current market price to attract​ investors, and the company will pay $3.00 per share in flotation costs.

a.  Calculate the​ after-tax cost of debt.

b.  Calculate the cost of preferred stock.

c.  Calculate the cost of common stock​ (both retained earnings and new common​ stock).

d.  Calculate the WACC for Dillon Labs.

Answer 1

a). To find the kD, we need to put the following values in the financial calculator:

INPUT	13		-(1015 * 0.96) = -974.4	7%*1,000=70	1,000
TVM	N	I/Y	PV	PMT	FV
OUTPUT		7.31

So, After-tax kD = kD x (1 - t) = 7.31% x (1 - 0.29) = 5.19%

b). kP = Annual Dividend / [P0 - fC] = $10 / [$92 - $4] = 11.36%

c). g = [FV/PV]^1/n - 1 = [4.89/3]^1/10 - 1 = 1.0501 - 1 = 0.0501, or 5.01%

kE(Retained Earnings) = [{D0 x (1 + g)} / P0] + g

= [($4.89 x 1.0501) / $50] + 0.0501 = 0.1027 + 0.0501 = 0.1528, or 15.28%

kE(New Common Stock) = [{D0 x (1 + g)} / {P0 - fC)] + g

= [($4.89 x 1.0501) / ($50 - $3)] + 0.0501 = 0.1093 + 0.0501 = 0.1593, or 15.93%

Average kE = [15.28% + 15.93%] / 2 = 31.21% / 2 = 15.60%

d). WACC = [wD x After-tax kD] + [wP x kP] + [wE x kE]

= [0.50 x 5.19%] + [0.15 x 11.36%] + [0.35 x 15.60%] = 2.60% + 1.70% + 5.46% = 9.76%