Northwest Utility Company faces increasing needs for capital. Fortunately, it ha
ID: 2735402 • Letter: N
Question
Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.
Historically, the corporation’s earnings and dividends per share have increased about 9.4 percent annually and this should continue in the future. Northwest’s common stock is selling at $76 per share, and the company will pay a $9.60 per share dividend (D1).
The company’s $120 preferred stock has been yielding 9 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $4.00 for preferred stock.
The company’s optimum capital structure is 40 percent debt, 20 percent preferred stock, and 40 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.
Compute the cost of debt, Kd (use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Compute the cost of preferred stock, Kp. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Compute the cost of common equity in the form of retained earnings, Ke. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.
Historically, the corporation’s earnings and dividends per share have increased about 9.4 percent annually and this should continue in the future. Northwest’s common stock is selling at $76 per share, and the company will pay a $9.60 per share dividend (D1).
The company’s $120 preferred stock has been yielding 9 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $4.00 for preferred stock.
The company’s optimum capital structure is 40 percent debt, 20 percent preferred stock, and 40 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.
Explanation / Answer
a.
The cost of debt is related to the cost of debt for other debt issues of the same risk class. Although, in actuality, the rate Northwest might pay will not be exactly equal to Pacific Bell, it should be close enough to serve as an approximation. Both utilities are rated Aa3.
Kd = Yield(1-T) = 8.33%(1-0.40)
= 3.33%
b.
Dp = $120*0.09 = $10.80
Kp = Dp/(Pp-F)
= $10.80/(120-4) = 0.0931 or 9.31%
c.
Ke = D1/P0 + g
= $9.60/$76 + 0.094 = 0.2203 or 22.03%
d.
Cost(after-tax)
Weights
Weighted Cost
Debt (kd)
3.33%
40%
1.33%
Preferred Stock (kp)
9.31%
20%
1.86%
Common Equity (ke)
22.03%
40%
8.81%
Weighted Average Cost of Capital (ka)
12%
Cost(after-tax)
Weights
Weighted Cost
Debt (kd)
3.33%
40%
1.33%
Preferred Stock (kp)
9.31%
20%
1.86%
Common Equity (ke)
22.03%
40%
8.81%
Weighted Average Cost of Capital (ka)
12%
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