Question

Need assistance with A, B, C, D

Calculation of individual costs and WACC 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: 30% long-term debt, 25% preferred stock, and 45% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 26%. Debt The firm can sell for $1005 a 20-year, $1,000-par-value bond paying annual interest at a 11.00% coupon rate. A flotation cost of 3% of the par value is required. Preferred stock 10.00% (annual dividend) preferred stock having a par value of $100 can be sold for $90. An additional fee of $5 per share must be paid to the underwriters. Common stock The firm's common stock is currently selling for $59.43 per share. The stock has paid a dividend that has gradually increased for many years, rising from $3.00 ten years ago to the $4.44 dividend payment, Do, that the company just recently made. If the company wants to issue new new common stock, it will sell them $3.50 below the current market price to attract investors, and the company will pay $4.00 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. a. The after-tax cost of debt using the bond's yield to maturity (YTM) is %. (Round to two decimal places.)

Answer 1

a)
FV = 1000
PV = 1005 * (1 - 3%) = 974.85
Nper = 20
PMT = 1000 * 11% = 110

Before tax cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(20,110,-974.85,1000)
= 11.32%

After tax cost of debt = Before tax cost of debt * (1 - tax rate)
= 11.32% * (1 - 0.26)
= 8.38%

After tax cost of debt = 8.38%

b)
Annual dividend = $100 * 10% = $10

Cost of preferred stock = Annual dividend / (Share value - floatation cost)
= $10 / ($90 - $5)
= $10 / $85
= 11.76%

c)
Dividend year 1 = $3
Dividend year 10 = $4.44

Growth rate can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(10,0,-3,4.44)
= 4%

Next year dividend = $4.44 * (1 +4%) = $4.62

Cost of common stock = Next year dividend / (Share value - costs) + growth rate
= $4.62 / ($59.43 - $3.50 - $4) + 4%
= $4.62 / $51.93 + 4%
= 12.89%

Cost of retained earnings = Next year dividend / Share value + growth rate
= $4.62 / $59.43 + 4%
= 11.77%

Average cost of equity = (12.89% + 11.77%) / 2 = 12.33%

d)
WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (Weight of common stock * cost of common stock)

= (30% * 8.38%) + (25% * 11.76%) + (45% * 12.33%)
= 2.51% + 2.94% + 5.55%
= 11%