Question

QUESTION 2: Dover Port Terminal reported after-tax earnings available to common stockholders of $6,400,000. From these earnings, Dover paid a dividend of $0.50 on each of its 6,000,000 common shares outstanding. The company has determined its optimal capital structure which is composed of the following sources and target market value proportions. Source of Capital Target Market Proportion Long-Term Debt 60% Common Stock 40% Debt: Dover can issue $1,000 par value, 8% coupon (with interest paid annually), 10-year bonds that can be sold at par. Flotation cost would amount to $20 per bond. Dover tax rate is 30%. FU- no Common Stock: The market price for the common stock is $3.60 and dividends are expected to grow at a rate of 8% per year for some foreseeable future. New common stock issue will attract a flotation cost of $0.40 per share. a) What is Dover WACC if equity capital comes from retained earnings? (9 marks) b) What is the new WACC when retained earnings are exhausted? (7 marks) c) At what level of total financing will cost of equity increase that will lead to an increase in WACC as determined in questions (a) and (b) above? (4 marks) [Total: 20 marks] 1000 x 20- 20000

Answer 1

a.Dover's WACC if equity capital comes from retained earnings

Cost of long-term debt:

Using the formula to find price/PV of bonds,

Price/PV=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, Price/PV is given as par value= $ 1000 ,here taken as the net proceeds , net of flotation costs, ie. 1000-20= $ 980

Pmt.= the annual $ coupon amt.= 1000*8%= $ 80

r= the before-tax annual yield --- to find out?? That is the cost of the bond

n=no.of annual compounding periods to maturity =10

FV=Face value= $ 1000

With these values, we can find the cost of the bond as

980=(80*(1-(1+r)^-10)/r)+(1000/(1+r)^10)

Solving for r, we get the before-tax annual yield as

8.30213%

Now the after-tax annual cost=

Before-tax cost*(1-Tax rate)

8.30213%*(1-30%)=

5.81%

If equity capital comes from retained earnings

There will be no flotation costs

All the other calculations are the same as for new equity

Using the dividend discount formula for constant groth of dividends,

ke=(D1/P0)+g

where, ke= the cost of equity(retained Earnings)=to be found out??

D1=D0*(1+g), ie. 0.5*(1+8%)=0.54

P0= current market price of the stock= $ 3.60

g= the constant growth rate= 8% p.a.

so, ke=(0.54/3.60)+8%=

23%

Now, the WACC=

(Wt. bonds*Cost bonds)+(Wt. RE*Cost RE)

ie.(60%*5.81%)+(40%*23%)=

12.69%

b.Dover's new WACC if retained earnings are exhausted & new equity is issued:

After-tax Cost of long-term debt is the same as in a.

5.81%

Cost of new equity:

In the same formula for cost of retained earnings , as above,

in the place of current market price,

we need to substitute with the net proceeds (net of flotation costs)of the issue

ie. 3.60-0.40= $ 3.20

so, it is now, ke=(0.54/3.20)+8%=

24.88%

Now, the WACC=

(Wt. bonds*Cost bonds)+(Wt. RE*Cost RE)

ie.(60%*5.81%)+(40%*24.88%)=

13.44%

c.From the given details,
After-tax earnings available to SH=	6400000
Less: Dividends paid(6000000 sh.*$ 0.50)	3000000
Retained amt.=	3400000

As long as the requirement for equity finance is below or equal to $ 3400000, the cost of equity will be 23% (as in a .above)

If the requirement exceeds $ 3400000, the cost of equity will be 24.88%( as in b.)

in any case, WACC will increase when either

i. weights of the different types of capital , to the total financing , increases ;and/or

ii.Cost of the component-capitals increase.

so, when $ amts. Increase, the proportional weight also increases.

In any case,when equity % goes above 40% of the total financing, that will lead to increase in cost of equity & subsequent increase in WACC--in both the cases.