P9–17 Calculation of individual costs and WACC Dillon Labs has asked its financi
ID: 2383491 • Letter: P
Question
P9–17 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: 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.
It is expected that to attract buyers, 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. (Assume that rr = rs.)
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the WACC for Dillon Labs.
Explanation / Answer
a. Calculate the after-tax cost of debt.
Before Tax Cost of Debt = rate(nper,pmt,pv,fv)
nper = 10
pmt = 10%*1000 = 100
pv (price after flotation cost) = 980 - 3%*1000 = 950
fv ( Face Value) = 1000
Before Tax Cost of Debt = rate(10,100,-950,1000)
Before Tax Cost of Debt = 10.84 %
After Tax Cost of Debt = Before Tax Cost of Debt *(1-tax rate)
After Tax Cost of Debt = 10.84*(1-40%)
After Tax Cost of Debt = 6.50%
b. Calculate the cost of preferred stock.
Cost of Preferred Stock = Annual Dividend/Current price after underwriter cost
Cost of Preferred Stock = 8/(65-2)
Cost of Preferred Stock = 12.70%
c. Calculate the cost of common stock.
Growth rate = Retention ratio *ROE
ROE= (4/60%)50 = 13.33%
Retention ratio = (1-60%)= 40%
Growth rate = 13.33%*40% = 5.33%
Cost of common stock = Expected Dividend/(Current Selling Price - under priced - flotation Cost) +
Cost of common stock = 4/(50-5-3) + 5.33%
Cost of common stock = 14.85%
d. Calculate the WACC for Dillon Labs.
WACC = Weight of Common Stock* Cost of Common Stock + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt
WACC = 50%*14.85 + 10%*12.70 + 40%*6.50
WACC = 11.30%
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