Determine The Weighted Average Cost Of Capital Based On ✓ Solved

Determine the weighted average cost of capital based on

Berkshire Instruments, represented by Al Hansen, seeks to determine the firm's weighted average cost of capital (WACC) based on two approaches: retained earnings and new common stock. In order to achieve this, it is crucial to analyze the firm's current financial structure as outlined in the provided financial data.

Initially, Al Hansen must calculate the cost of capital using retained earnings. To do so, we need to determine the weighted average cost of capital for the firm's existing capital structure, which comprises bonds, preferred stock, and common equity, using the information contained in Figure 1. The total amount of long-term financing is $18 million, with the specified composition of 60% in common equity.

Calculating the Weights of the Capital Structure

The current capital structure can be summarized as follows:

• Bonds payable: $6,120,000
• Preferred stock: $1,080,000
• Common stock and retained earnings: $10,800,000 (Total common equity)

To find the weights, we calculate each component's proportion of the total long-term financing:

• Weight of Debt (Bonds): $6,120,000 / $18,000,000 = 0.34 (34%)
• Weight of Preferred Stock: $1,080,000 / $18,000,000 = 0.06 (6%)
• Weight of Common Equity: $10,800,000 / $18,000,000 = 0.60 (60%)

Determining Costs of Capital Components

Next, to compute the WACC accurately, we must derive the costs of each component of capital:

1. Cost of Debt

Using Rollins Instruments' bond information, the cost of debt can be determined based on the yield of a similar Baa rated bond currently selling for $890 with a coupon payment of 9.3%.

Cost of Debt = (Coupon Payment / Current Price) × (1 - Tax Rate)

A coupon payment of $1,000 par value bonds, 0.093 * $1,000 = $93. The new price is $890.

Hence, the cost of debt is:

Cost of Debt = ($93 / $890) × (1 - 0.35) = 0.1045 or 10.45%

2. Cost of Preferred Stock

The cost of preferred stock can be calculated using the formula:

Cost of Preferred Stock = Dividend / (Price - Flotation Cost)

With a dividend of $4.80 for Rollins Instruments preferred stock priced at $60 per share and attrition cost of $2.60, we have:

Cost of Preferred Stock = $4.80 / ($60 - $2.60) = $4.80 / $57.40 = 0.0836 or 8.36%

3. Cost of Common Equity

Using the Dividend Valuation Model to find the cost of equity:

Cost of Equity = (D1 / P0) + g

Where:

• D1 (next year's expectation of dividends) = Earnings per share × Dividend payout ratio
• g = Growth rate of dividends

Given earnings of $3 per share and a 40% payout ratio:

D1 = $3 × 0.40 = $1.20. The growth rate can be calculated using historical growth rates. For instance, analyzing the growth from 0.82 to 1.20 over four years gives:

g = (1.20 - 0.82) / 0.82 = 0.4634 or 46.34%

Hence, cost of equity:

Cost of Equity = ($1.20 / $25) + 0.4634 = 0.048 + 0.4634 = 0.5114 or 51.14%

WACC Calculation With Retained Earnings

Using the weights and costs derived above:

WACC = (Weight of Debt × Cost of Debt) + (Weight of Preferred × Cost of Preferred) + (Weight of Equity × Cost of Equity)

Calculating this gives:

Recomputing WACC with New Common Stock

Following the same component costs and weights but substituting retained earnings with new common stock will not change the weights. Thus, we compute:

1. Cost of New Common Stock

Replacing retained earnings with the cost of new common equity will typically increase the cost due to flotation costs. The adjusted cost of new equity would consider the flotation cost as:

Cost of New Equity = {D1 / (P0 - Flotation Cost)} + g

Let’s reevaluate: Cost of New Common Equity = ($1.20 / ($25 - $2.00)) + 0.4634 = ($1.20 / $23) + 0.4634 = 0.0522 + 0.4634 = 0.5156 or 51.56%

Then updating the WACC:

WACC = (0.34 × 0.1045) + (0.06 × 0.0836) + (0.60 × 0.5156) = 0.0355 + 0.0050 + 0.3094 = 0.3495 or 34.95%

Summary of Key Findings

The primary differentiation between the two approaches lies in the method of obtaining capital for common equity—which affects the resultant WACC. The first approach utilizing retained earnings yielded a lower WACC of 34.7%, while the second employing new stock issuance resulted in a slightly higher WACC of 34.95%. This increase in capital cost profiles may significantly influence investment decisions and future financing adjustments.

Based on these findings, I would recommend maintaining the use of retained earnings wherever feasible due to the lower cost of capital inherent in that option. This strategy not only strengthens the balance sheet but also minimizes financial pressure.

References

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