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

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

1)

Here is the formula for WACC.
WACC = wd*kd(1 - T) + wps * kps + wce * kcs
wd = weight of debt, kd = cost of debt, T = tax rate, wps = weight preferred stock.
kps = cost preferred stock, wce = weight common stock, kcs = cost common stock.
Retained earnings and the sale of new common stock are both used in regard to common equity.

2)
Capital-asset-pricing-model (CAPM) approach
Bond-yield-plus-premium approach
Discounted cash flow (DCF) approach

CAPM is the most widely used method for estimating the cost of
equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. DCF tends to be the most reliable way to calculate the cost of equity when a company pays dividends.

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