Reference no: EM133130316

Question - The composition of Dillan Laboratories' capital structure are as follows:

Long-Term Debt 45%

Preferred stock 15%

Common stock 40%

The President is contemplating of issuing bonds and stocks to bring the capital structure to this level:

Long-Term Debt 50%

Preferred stock 20%

Common stock 30%

He specifically wants to know if this new composition will have a positive impact on the company's weighted average cost of capital (WACC).

For additional long-term debt, the firm can sell a 10-year, $1,000 par-value bond paying annual interest of 8% coupon rate for $1,020. The flotation cost is 3% of the par value is required

Additional preferred stocks having a par value of $100 can be sold for $97 per share. Each preferred stock is guaranteed to receive a 6% annual dividend. For these shares to be sold in the market, an additional $1.50 per share must be paid to the underwriters.

Common stock of the firm is currently selling for $75 per share. The stock has paid a dividend that has gradually increased, rising from $3.00 ten years ago to $4.50 dividend payment that the company made recently.

If the company wants to issue new common shares, it will sell them $2 below the current market value to attract investors, and the company will pay $1.50 per share in flotation costs.

The firm's tax rate is 25%.

Required -

1. Determine the firms current WACC by doing the following (round-off figures to 2 decimal points):

a) Determine the before-tax and after-tax cost of debt using estimation.

b) Calculate the cost of the preferred stock

c) Compute for the cost of the common stock (retained earnings)

d) Figure out the cost of capital for newly issued common stock.

2. If the firm decides to change its capital structure - 50% debt, 20% preferred stock and 30% common stock, what will be its new WACC.