Must Show Work And Be Done On Excel You Are A Consultant

Must Show Work And Be Done On Excel1you Are A Consultant To Pillbr

You are a consultant to Pillbriar Company. Pillbriar’s target capital structure is 36% debt, 14% preferred, and 50% common equity. The interest rate on new debt is 7.8%, the yield on the preferred is 7.00%, the cost of retained earnings is 11.75%, and the tax rate is 38%. The firm will not be issuing any new stock.

1. What is Pillbriar's WACC? 2. What are three methods for estimating the cost of common stock from retained earnings? Which of these methods provides the most accurate and reliable estimate?

Paper For Above instruction

The Weighted Average Cost of Capital (WACC) is a crucial metric used by companies to evaluate the cost of capital from all sources, including debt, preferred stock, and equity, weighted by their respective proportions in the company's capital structure. Calculating the WACC provides insights into the company's cost of financing investments and helps in making strategic financial decisions. This paper explores the calculation of Pillbriar Company’s WACC based on given data and discusses three methods for estimating the cost of common stock from retained earnings, emphasizing which method is most accurate and reliable.

Calculation of WACC for Pillbriar

The provided data indicates that Pillbriar’s capital structure comprises 36% debt, 14% preferred stock, and 50% common equity. The respective costs are 7.8% for debt, 7.00% for preferred stock, and 11.75% for retained earnings, with a corporate tax rate of 38%. Given that the company will not issue new stock, the cost of retained earnings reflects its cost of equity. To compute the WACC, each component's contribution is multiplied by its cost, adjusted where necessary for taxes in the case of debt.

First, we calculate the after-tax cost of debt:

  • After-tax cost of debt = 7.8% × (1 – 0.38) = 7.8% × 0.62 = 4.836%

Next, we compute the weighted components of the WACC:

  • Weighted cost of debt = 36% × 4.836% = 1.741%
  • Weighted cost of preferred = 14% × 7.00% = 0.98%
  • Weighted cost of equity = 50% × 11.75% = 5.875%

Adding these together yields the company's WACC:

  • WACC = 1.741% + 0.98% + 5.875% = 8.596%

Thus, Pillbriar's approximate WACC is 8.60%, representing the average rate that the company must pay to finance its assets and investments considering its capital structure and costs.

Methods for Estimating the Cost of Common Stock from Retained Earnings

Estimating the cost of common stock from retained earnings is vital for internal valuation and decision-making, especially when issuing new equity is not an option. Three commonly used methods include the Dividend Discount Model (DDM), the Earnings Capitalization Ratio, and the Bond Yield plus Risk Premium method. Each has unique strengths and limitations, making their comparative accuracy critical for financial assessments.

1. Dividend Discount Model (DDM)

The DDM, particularly the Gordon Growth Model, estimates the cost of equity as the expected dividend per share divided by the current stock price, adjusted for growth:

Ke = (D1 / P0) + g

where D1 is the expected dividend next year, P0 is the current stock price, and g is the expected growth rate of dividends. This method relies heavily on accurate dividend projections and growth assumptions. It is highly regarded when a company has a stable dividend policy and predictable growth.

2. Earnings Capitalization Ratio

This approach calculates the cost of equity by dividing earnings per share (EPS) by the current stock price:

Ke = EPS / P0

Adjustments are made for retention ratios and growth expectations. It offers a straightforward estimation but can be less accurate if earnings are volatile or cyclical.

3. Bond Yield plus Risk Premium

This method adds a risk premium to the company's long-term bond yield:

Ke = Bond yield + Risk premium

The approach inherently incorporates market-based credit risk but often underestimates the total equity risk as it relies on bond yields, which usually reflect lower risk premiums than equities.

Most Accurate and Reliable Method

Among the three, the Dividend Discount Model generally provides the most accurate and reliable estimate, particularly for companies with stable dividends and growth rates. Its valuation-centric approach aligns closely with investors' expectations and market realities, making it a preferred method for internal use by firms. Nevertheless, it requires reliable dividend forecasts and assumptions of growth, making it less suitable for companies with fluctuating dividends. The earnings capitalization ratio offers simplicity but is less precise, especially when earnings are highly volatile. The bond yield plus risk premium method is market-based but often underrepresents the actual risk associated with equities, especially in turbulent markets.

Conclusion

Calculating Pillbriar’s WACC involves integrating the costs of debt, preferred stock, and equity, considering their proportions in capital structure and applicable taxes. The WACC serves as a crucial benchmark for investment decisions and valuation. For estimating the cost of common equity from retained earnings, the Dividend Discount Model stands out as the most accurate and reliable method, provided dividend projections are stable and growth is predictable. As companies and investors rely on precise cost estimations, understanding the strengths and limitations of each method ensures better financial decision-making and valuation accuracy.

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