91影视

Question: Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwest鈥檚 treasurer is trying to determine the corporation鈥檚 current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

Historically, the corporation鈥檚 earnings and dividends per share have increased about 8.2 percent annually and this should continue in the future.

Northwest鈥檚 common stock is selling at \(64 per share, and the company will pay a \)6.50 per share dividend (D1).

The company鈥檚 \(96 preferred stock has been yielding 8 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be \)6.00 for preferred stock.

The company鈥檚 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:

Issues	Moody鈥檚 Rating	Price	Yield to maturity
Utilities:
Southwest Electric Power鈥�7录 2023	Aa2	$895.18	8.74%
Pacific Bell鈥�73鈦� 8 2025	Aa3	891.25	8.73
Pennsylvania Power & Light鈥�8陆 2022	A2	970.66	8.77
Industrials:
Johnson & Johnson鈥�6戮 2023	Aaa	880.24	8.55%
Dillard鈥檚 Department Stores鈥�71鈦� 8 2023	A2	960.92	8.22
Marriott Corp.鈥�10 2015	B2	1,035.10	9.77

Compute the answers to the following questions from the information given:

a. Cost of debt, Kd. (Use the accompanying table鈥攔elate to the utility bond credit rating for yield.)

b. Cost of preferred stock, Kp.

c. Cost of common equity in the form of retained earnings, Ke.

d. Weighted average cost of capital

Step by step solution

01

Definition of Cost of Capital

Cost of capital refers to a metric used to calculate the minimum return a business must earn to cover the cost incurred in the capital project.

02

Cost of debt

The company is in a credit rating of Aa3. Therefore, the cost of debt will be:

$$\begin{gathered} {\mathit{K}}_{\mathbf{d}}\mathbf{=}\mathit{Y}\left(1-T\right) \\ \mathbf{=}\mathbf{8}\mathbf{.}\mathbf{73}\mathbf{\%}\mathbf{脳}\left(1-0.40\right) \\ \mathbf{=}\mathbf{5}\mathbf{.}\mathbf{24}\mathbf{\%} \end{gathered}$$

03

Cost of preferred stock

$$\begin{gathered} {\mathit{K}}_{\mathbf{P}}\mathbf{=}\frac{{\mathbf{D}}_{\mathbf{P}}}{{\mathbf{P}}_{\mathbf{p}}\mathbf{-}\mathbf{F}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{7}\mathbf{.}\mathbf{68}}{\mathbf{\$}\mathbf{96}\mathbf{-}\mathbf{\$}\mathbf{6}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{7}\mathbf{.}\mathbf{68}}{\mathbf{\$}\mathbf{90}} \\ \mathbf{=}\mathbf{8}\mathbf{.}\mathbf{53}\mathbf{\%} \end{gathered}$$

04

Cost of common equity in the form of retained earnings

$$\begin{gathered} {\mathit{K}}_{\mathbf{e}}\mathbf{=}\frac{\mathbf{C}\mathbf{u}\mathbf{r}\mathbf{r}\mathbf{e}\mathbf{n}\mathbf{t}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}}{\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{k}\mathbf{e}\mathbf{t}\mathbf{p}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}}\mathbf{+}\mathit{G}\mathit{r}\mathit{o}\mathit{w}\mathit{t}\mathit{h}\mathit{r}\mathit{a}\mathit{t}\mathit{e} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{6}\mathbf{.}\mathbf{50}}{\mathbf{\$}\mathbf{64}}\mathbf{+}\mathbf{8}\mathbf{.}\mathbf{2}\mathbf{\%} \\ \mathbf{=}\mathbf{18}\mathbf{.}\mathbf{35}\mathbf{\%} \end{gathered}$$

05

Weighted average cost of capital

Particular	(1) Cost after tax	(2) Weights	(3) Weighted Cost
Debt	5.24%	55%	2.90
Common stock	18.35%	25%	4.59%
Preferred stock	8.53%	20%	1.71%
Total	9.2%

Unlock Step-by-Step Solutions & Ace Your Exams!

• Full Textbook Solutions

  Get detailed explanations and key concepts

• Unlimited Al creation

  Al flashcards, explanations, exams and more...

• Ads-free access

  To over 500 millions flashcards

• Money-back guarantee

  We refund you if you fail your exam.

Over 30 million students worldwide already upgrade their learning with 91影视!