Unformatted text preview: can use this cost in the investment decision-making
process. LG4 11–12 WACC—Book weights and market weights Webster Company has compiled
the information shown in the following table. Source of capital Book value Market value Long-term debt $4,000,000 $3,840,000 Preferred stock 40,000 60,000 13.0 1,060,000 3,000,000 17.0 $5,100,000 $6,900,000 Common stock equity
Totals After-tax cost
6.0% a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences. LG4 11–13 WACC and target weights After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target
market value weights shown in the following table. Source of capital Target market
value weight Long-term debt 30% Preferred stock 15 Common stock equity
100% The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated
to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost
of new common stock is estimated to be 18.0%. All of these are after-tax rates.
The company’s debt represents 25%, the preferred stock represents 10%, and
the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant
amount of retained earnings available and does not expect to sell any new common stock.
a. Calculate the weighted average cost of capital on the basis of historical market value weights. CHAPTER 11 The Cost of Capital 499 b. Calculate the weighted average cost of capital on the basis of target market
value weights. LG4 LG2 LG5 11–14 Cost of capital and break point Edna Recording Studios, Inc., reported earnings available to common stock of $4,200,000 last year. From that, the company
paid a dividend of $1.26 on each of its 1,000,000 common shares outstanding.
The capital structure of the company includes 40% debt, 10% preferred stock,
and 50% common stock. It is taxed at a rate of 40%.
a. If the market price of common stock is $40 and dividends are expected to
grow at a rate of 6% a year for the foreseeable future, what is the company’s
cost of financing with retained earnings?
b. If flotation costs on new shares of common stock amount to $1.00 per share,
what is the company’s cost of new common stock financing?
c. The company can issue $2.00 dividend preferred stock for a market price of
$25.00 per share. Flotation costs would amount to $3.00 per share. What is
the cost of preferred stock financing?
d. The company can issue $1,000 par, 10% coupon, 5-year bonds that can be
sold for $1,200 each. Flotation costs would amount to $25.00 per bond.
Use the estimation formula to figure the approximate cost of new debt
e. What is the maximum investment that Edna Recording can make in new
projects before it must issue new common stock?
f. What is the WACC for projects with a cost at or below the amount calculated in part e?
g. What is the WMCC for projects with a cost above the amount calculated in
part e (assuming that debt across all ranges remains at the percentage cost
calculated in part d)? LG3 LG4 11–15 Calculation of specific costs, WACC, and WMCC Dillon Labs has asked its
financial manager 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%. LG5 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 (2004) 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. 500 PART 4 Long-Term Financial Decisions Year Dividend 2003 $3.75 2002 3.50 2001 3.30 2000 3.15 1999 2.85 It is expected that in order to sell, 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.
a. Calculate the specific cost of each source of financing. (Assume that
b. If earnings available to common shareholders are expected to be $7
million, what is the break point associated with the exhaustion of retained
c. Determine the weighted average cost of capital between zero an...
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