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: 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 (2004) 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 Dividend

2003                       $3.75

2002                       3.50

2001                       3.30

2000                      3.15

1999                      2.85

It is expected that in order to sell, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings.

a. Calculate the specific cost of each source of financing. (Assume that kr

ks.)

b. If earnings available to common shareholders are expected to be $7 million, what is the break point associated with the exhaustion of retained earnings?

c. Determine the weighted average cost of capital between zero and the break point calculated in part b.

d. Determine the weighted average cost of capital just beyond the break point calculated in part b

Answer 1

a)
After tax cost of debt
Face Value = FV	$1,000.00
Present Value = PV	$980.00
Annual coupon rate	10.00%
Period	10
Annual coupon Payment	$100.00
Floatation Cost	3.00%
Net proceeds after flotation costs = ($980 x (1-3%)	$950.60
Cost of debt before Tax = Rate(20,100,-950.60,1000)	10.83%
After tax cost of debt = 10.83% x (1 - 40%)	6.50%
b)
Cost of Preferred Stock = Dividend/ Current price - Fees
Cost of Preferred Stock = $100 x 8% / $65 - $2	12.70%
c)
Cost of Equity
Growth Rate = [(Ending Value/ Beginning Value)^(1/n)]-1
Growth Rate = [(4/ 2.85)^(1/10)]-1	3.45%
Cost of Retained Earnings = D0 x (1+g)/P0 + G
Cost of Retained Earnings = 4 x (1+3.45%)/50 + 3.45%	11.72%
Cost of new common stock equity = 4 x (1+3.45%)/(50 -5-3) +3.45%	13.30%
Average = (11.72% + 13.30%)/2	12.51%
d)
WACC with retained earnings = 40% x 6.50% + 10% x 12.70% + 50% x 11.72%	9.73%
WACC with new common equity = 40% x 6.50% + 10% x 12.70% + 50% x 14.30%	10.52%
WACC with average equity = 40% x 6.50% + 10% x 12.70% + 50% x 12.51%	10.13%