Question

P9-17 Calculation of individual costs and WACC Dillon Labs has asked its financial man- ager 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, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 40%. Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond. Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters. Common stock The firm's common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2016) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table. Year 2015 2014 2013 2012 2011 Dividend $3.75 3.50 3.30 3.15 2.85

Answer 1

Answer:

Cost of debt:

Par value = $1,000

Annual coupon = 1000 * 10% = $100

Amount realized per bond = 980 - 1000 * 3% = $950

Time to maturity = 10

Hence:

Cost of debt = RATE (nper, pmt, pv, fv, type) = RATE(10, 100, -950, 1000, 0) = 10.84%

Cost of equity:

Growth rate = (3.75 / 2.85) ^(1/4) - 1 = 7.10%

Cost of equity = (dividend next year / price) + Growth rate = (4 / 50) + 7.10% = 15.10%

Cost of Preferred stock:

Cost of preferred stock = Annual dividend / (Price - Underwriter fees) = (100 * 8%) / (65-2) = 12.70%

WACC:

WACC = Cost of equity * weight of equity + Cost of preferred stock * Weight of preferred stock + Cost of debt * (1 - Tax rate) * weight of debt

WACC = 15.10% * 50% + 12.70% * 10% + 10.84% * (1 - 40%) * 40% = 11.42%

WACC = 11.42%