Northwest Utility Company faces increasing needs for capital. Fortunately, it ha
ID: 2764859 • 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 8.2 percent annually and this should continue in the future. Northwest’s common stock is selling at $64 per share, and the company will pay a $6.50 per share dividend (D1).
The company’s $96 preferred stock has been yielding 8 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $6 for preferred stock.
The company’s optimum capital structure is 55 percent debt, 20 percent preferred stock, and 25 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 8.2 percent annually and this should continue in the future. Northwest’s common stock is selling at $64 per share, and the company will pay a $6.50 per share dividend (D1).
The company’s $96 preferred stock has been yielding 8 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $6 for preferred stock.
The company’s optimum capital structure is 55 percent debt, 20 percent preferred stock, and 25 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
Calculation of Cost of Debt
Kd = Rd ( 1 - t )
Where,
Kd = Post tax cost of debt
Rd = Coupan rate of interest
r = Rate of income tax
Kd = Rd ( 1 - t )
= 8.73 ( 1 - 0.40 )
Kd = 5.24%
Calculation of Cost of Preferred Shares
Kp = ( Preferred Stock Dividend ) / Market Price ( 1 - Floatation Cost )
Where,
Kp = Cost of Preferred Share
Kp = ( Preferred Stock Dividend ) / Market Price ( 1 - Floatation Cost )
= 8 ( 96 - 6 )
Kp = 8.89%
Calculation of Cost of Equity
Ke = ( D1 / P0 ) + g
Where,
Ke = Cost of Equity
D1 = Next expected dividend
P0 = Current market price
g = Constant growth rate of dividend
Ke = ( D1 / P0 ) + g
= ( 6.50 / 64 ) + 0.082
Ke = 18.36%
Calculation of Weighted Cost of Capital
PARTICULARS WEIGHT COST WACC
Debt 0.55 5.24 2.88
Preferred Stock 0.20 8.89 1.78
Common Stock 0.25 18.36 4.59
WACC 1.00 9.25
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.