Compute the cost of preferred stock

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Reference no: EM132210708

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 6.4 percent annually and this should continue in the future. Northwest's common stock is selling at $73 per share, and the company will pay a $4.60 per share dividend (D₁).

The company's $114 preferred stock has been yielding 10 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $8.00 for preferred stock.

The company's optimal capital structure is 60 percent debt, 25 percent preferred stock, and 15 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.

Data on Bond Issues
Issue	Moody's Rating	Price	Yield to Maturity
Utilities:
Southwest electric power - 7 1/4 2023	Aa2	$940.18	8.35%
Pacific bell - 7 3/8 2025	Aa3	900.25	8.88
Pennsylvania power & light - 8 1/2 2022	A2	970.66	8.88
Industrials:
Johnson & Johnson - 6 3/4 2023	Aaa	890.24	8.66%
Dillard's Department Stores - 7 3/8 2023	A2	950.92	8.66
Marriot Corp. - 10 2015	B2	1,080.10	9.55

a. Compute the cost of debt, K_d (use the accompanying table-relate to the utility bond credit rating for yield.)

b. Compute the cost of preferred stock K_p.

c. Compute the cost of common equity in the form of retained earnings, K_e.

d. Calculate the weighted cost of each source of capital and the weighted average cost of capital.

Reference no: EM132210708

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