1. You are a consultant to Pillbriar Company. Pillbriar’s target capital structu

Question

1. You are a consultant to Pillbriar Company. Pillbriar’s target capital structure is 36% debt, 14% preferred, and 50% common equity. The interest rate on new debt is 7.8%, the yield on the preferred is 7.00%, the cost of retained earnings is 11.75%, and the tax rate is 38%. The firm will not be issuing any new stock. What is Pillbriar's WACC?
2. What are three methods for estimating the cost of common stock from retained earnings? Which of these methods provides the most accurate and reliable estimate?

Explanation / Answer

This was asked yesterday: We know WACC = Kd*(1-T)*Wd + Ks*Ws +Wp*Kp where Wp, Ws&Wd are weights of Pref stock, Equity & Debt, Kp, Kd & Ks are cost of Pref stock, Debt & Cost of equity. So we have Wd = 36%, Wp=14% & Ws=50%. Aso we have Kd = 7.8%, Ks = 11.75% & Kp = 7% and T=38% SO WACC = 7.8%*(1-38%)*36% + 11.75%*50% + 7%*14% =8.60% The three methods are : 1. Dividend Growth Model (Discounted cash flow model): Dividends paid to common shareholders along with the overall expected growth rate is used to calculate a cost for the common stock. The formula for calculating the cost of common stock is: (Dividends in Year 1 / Market Value of Stock) + Overall Growth Rate. 2. Capital Asset Pricing Model (CAPM) : The CAPM is the most widely used approach to calculating the cost of common stock. The CAPM uses three components to calculate the cost of common stock - (1) rf is the risk free rate earned by investors (such as U.S. Treasury Bonds; (2) b is the beta coefficient which expresses the risk of the common stock in relation to the market; and (3) rm is the rate earned in the market (such as the Standard & Poor's 500 Composite Index). The CAPM formula is Ccs = rf + b ( rm - rf ). 3. Bond-yield-plus-premium model: A simple approach to calculating the cost of common stock is to add a risk premium to the cost of debt. The formula is Ccs = Cd + risk premium. The risk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders CAPM is the most widely used approach to calculating the cost of common stock

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