Reference no: EM131988477

Solar Utility is a rapidly expanding supplier of energy in the southwestern US. The firm has 5,000,000 shares of common stock outstanding on which it recently paid a $2 dividend. The common stock is currently priced at $30 per share. The firm wishes to maintain a payout ratio of 50%. The current earnings per share of $4 are expected to increase at an annual rate of 6% for the foreseeable future.

The firm also has two long-term bond issues outstanding. An issue of 100 million bearing a 12% interest rate has been outstanding for two years and the bonds are selling at face (par) value. A prior bond issue of 60 million will mature in the forthcoming period and must be refunded with a new issue of bonds. The new 10 year bonds will have a coupon rate of 10% and are expected to sell for $900.

Solar utilizes preferred stock as a financing source and has 300,000 shares of $100 par value preferred shares outstanding. The firm pays an annual dividend of $6 on the preferred stock, which is currently selling at $75.

The firm expects to continue to provide capital financing in the following proportions in the future: long-term debt, 40%; preferred stock, 10%; common stock, 20%; and retained earnings, 30%.

If the issue cost of common stock is 8% and preferred stock is 4% of the amount issued, and the firm is in a 34% tax bracket, compute the weighted average cost of capital (the minimum return that the firm should strive to earn).

Instructions: Complete the required analysis. Show all your work and label each section: Step1, Step 2, etc... on a separate sheet of paper. Fill in the chart to calculate the weighted average cost of capital. Staple these 4 pages together in order along with a fourth page (your work). I will be grading the chart, so be sure to fill in each section of the chart. When you have filled in the weighted costs in the last column, add these up to find the WACC. This project is as much about extraction of relevant information as it is about your ability to compute the WACC. So you may need to review.

Set up:

Step 1:

What is the capital structure? (the percentages of debt, common stock, and preferred stock) You will have retained earnings and the issuance of new common equity. The information regarding the capital structure is found in the fourth paragraph.

Step 2:

Calculate the cost of debt. Remember that you use the time value of money register on your calculator to value debt. It would be helpful to you to draw a timeline. Information about debt is found in paragraph two. Recall that we are interested only in the cost of NEW DEBT "because our primary concern with the cost of capital is to use it for capital budgeting decisions." Don't forget to account for taxes. Refer to your text for a review of valuing debt (bonds).

Step 3:

Calculate the cost of preferred stock. This should be very easy. The only problem you should encounter is that dealing with the flotation cost. Information dealing with the flotation cost is found in the last paragraph. The formula to account for the flotation cost is P(1-f), where P is the price of the security and f is the flotation cost (as a percentage) of issuing the security. For a review of preferred stock valuation, see your text. Remember that preferred stock is valued like zero growth common stock (g=0).

Step 4:

Calculate the cost of retained earnings. Recall that there is no flotation cost associated with simply moving a number from the income statement to the statement of retained earnings, which is transferred to the balance sheet. It is important to remember that we're interested in the FUTURE EXPECTED DIVIDEND, not the just paid dividend. You must calculate the future expected dividend. Use the Gordon Model to value the retained earnings. Refer to your text for a discussion and the formulas. Information about retained earnings is found in paragraph 1.

Step 5:

Calculate the cost of new common stock. Most of the work you do here will be very similar to that which you did in step 4, only this time you'll account for flotation costs. The formula for this is similar to that of preferred stock. P(1-f). The firm is issuing new equity, not simply moving net income to retained earnings. For a discussion of flotation costs, see chapter 11.

Step 6:

Now that you have all of the costs and know the weights to assign to each, all you have to do is fill in chart:

This is the chart form of the WACC formula. You will have 4 component costs as opposed to 3.

Security

Weights (%)

Costs

Weighted costs (Weights * Cost)

Common stock

Retained Earnings

Preferred stock

Debt

WACC=

Step 1. Capital Structure

Step 2. Cost of Debt

Step 3. Cost of Preferred Stock

Step 4. Cost of Retained Earnings

Step 5. Cost of Common Stock

Step 6. WACC