Lancaster Engineering Inc (LEI) has the following capital structure, which it co

Question

Lancaster Engineering Inc (LEI) has the following capital structure, which it considers to be optimal. Long Term Debt 30% Preferred Stock 10% Common Stock 60% Total 100% • LEI can obtain capital in the following ways: • New Preferred Stock with a dividend of $11 can be sold at $97 to the public; however LEI will incur $2 of flotation costs for each share it sells. • Debt can be sold at a pre-tax cost of 12%. LEI’s tax rate is 40%. (Note that 12% is the pre-tax cost; all costs must be expressed on an after-tax basis so as to be comparable.) • LEI can sell its common stock for $60. However they expect underwriting fees to be $4 per share and an additional $2 per share in other flotation costs. They expect to pay a dividend on the common stock next year of $3.60 and it is expected that dividends will continue to grow at the historical rate of 9%. Required: 1. Determine the cost of each capital component 2. Determine the weighted average cost of capital (WACC) for LEI.

Explanation / Answer

Lancaster Engineering Inc All Amounts in $ 1. Cost of each capital component Preferred Stock Dividend = $ 11 Selling Price less Flotation Costs = $ 97 - $ 2 = $ 95 Cost of Preferred Stock = $ 11 / $ 95 = 11.58% Debt Pre Tax Cost 12% Tax Impact @ 40% 4.800% Post Tax Cost 7.200% Common Stock Expected Dividend Rate = $ 3.60 X 109% = 3.924 $ Selling Price less Costs involved = $ 60 - $ 4 - $ 2 = $ 54 Cost of Common Stock = $ 3.924 / $ 54 = 7.27% 2. Weighted Average Cost of Capital (WACC) Capital Component % Cost Weighted in Structure as above Cost Preferred Stock 10% 11.58% 1.16% Debt 30% 7.200% 2.16% Common Stock 60% 7.27% 4.36% WACC 7.68%

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