Principles of Managerial Finance, 14th edition P9–17: Calculation of individual

Question

Principles of Managerial Finance, 14th edition P9–17:

Calculation of individual costs and WACC Dillon Labs has asked its financial man ager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%.

Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond.

Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.

Common stock The firm’s common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2016) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table.

Year Dividend

2015 $3.75

2014 3.50

2013 3.30

2012 3.15

2011 2.85

It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings. (Assume that rr = rs.)

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the WACC for Dillon Labs.

*** Please answer all parts A thru D, and please answer in excel and show formula work. Thank you!***

Explanation / Answer

SOLUTION =

1) CALCULATION OF AFTER TAX COST OF DEBT

COST OF DEBT = Rd= I+PAR VALUE-Nd/N/PAR VALUE +Nd/2

I = INTEREST = $1000*10%=$100

PAR VALUE = $1000

N = NUMBER OF YEARS = 10

Nd = PRICE AFTER FLOATATION EFFECT= SALE VALUE - FLOATION COST+PREMIUM(DISCOUNT)= 980-3%*1000=$950

Rd= 100+1000-950/10/1000+950/2=105/975=10.76%

TAX RATE = 40%

AFTER TAX COST OF DEBT = Rd(1- TAX RATE)

=10.76(1-0.40)

=6.46%

2) CALCULATION OF COST OF PREFERRED STOCK

Rp= Dp/Np

Dp= ANNUAL DIVIDEND = 8%*$100= $8

Np=NET PRICE = SALE PRICE - ADDITIONAL FEES = $65-$2= $63

Rp = Dp/Np= 8/63= 12.70%

3) CALCULATION OF COMMON COST

USING CONSTANT DIVIDEND GROWTH MODEL

Rs= D1/P0+G

D1= DIVIDEND AT THE YEAR END= $4

P0 = SALE PRICE = $50

YEAR DIVIDEND

2015 $3.75

2014 3.50

2013 3.30

2012 3.15

2011 2.85

BY USING ABOVE

G = GROWTH RATE OF DIVIDEND= 7.10%

Re=$4/50+7.10%=15.10%

NEW COST OF EQUITY

Rn=D1/Nn+G

D1=DIVIDEND AFTER YEAR = $4

Nn= NEW VALUE PRICE PER SHARE = $45($50-$5)

G = GROWTH RATE = 7.10%

Rn =$4/45-$3 + 7.10% = 16.62%

4) CALCULATION OF WACC

WACC Ra =Wd*Rd+Wp*Rp+We*Re

Wd=WEIGHT OF DEBT = 40%

Wp= WEIGHT OF PREFERENCE CAPITAL = 10%

We = WEIGHT OF EQUITY SHARES = 50%

WACC (Ra) =0.40*6.46%+0.1*12.70%+0.5*15.10%

= 2.584%+1.27%+7.55%

= 11.40%

if firm issuing new stock

WACC = 2.584%+1.27%+0.5*16.62%=2.584%+1.27%+8.31%=12.164%

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