Question

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 35 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 6.2 percent annually and this should continue in the future. Northwest’s common stock is selling at $63 per share, and the company will pay a $5.50 per share dividend (D1). The company’s $94 preferred stock has been yielding 7 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $5.00 for preferred stock. The company’s optimum capital structure is 45 percent debt, 25 percent preferred stock, and 30 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.

Yield to Maturity Price $ Data on Bond Issues Moody's Issue Rating Utilities: Southwest electric power--7 1/4 2023 Aa2 Pacific bell--7 3/8 2025 Pennsylvania power & light--8 1/2 2022 Industrials: Johnson & Johnson--6 3/4 2023 Ааа Dillard's Department Stores--7 1/8 2023 Marriott Corp.--19 2015 B2 Aa3 A2 899.18 899.25 965.66 8.64% 8.63 8.66 879.24 950.92 1, 30.10 8.44% 8.33 9.96

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

Market Market value weights $ 30 0.30 value Cost % 14.93% =5.5/63+6.2% WACC (Cost %*Weights) 4.48% Common equity a) Cost of debt 5.61% b) Cost of preferred stock 7.39% Debt $ 45 0.45 2.52% 5.61% =8.63%*(1-35%) c) Cost of common equity 14.93%| Preferred stock $ 25 0 .25 1.85% 7.39% =94*7%/(94-5) d) Debt Preferred stock Common equity WACC 2.52% 1.85% 4.48% 8.85% Total $ 100 1.00 Weighted average cost of capital (WACC) 8.85%

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