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 8.6 percent annually and this should continue in the future. Northwest’s common stock is selling at $70 per share, and the company will pay a $7.20 per share dividend (D1).
The company’s $108 preferred stock has been yielding 7 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $5.00 for preferred stock.
The company’s optimum capital structure is 45 percent debt, 20 percent preferred stock, and 35 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 | $ | 925.18 | | 8.77 | % |
| Pacific bell––7 3/8 2025 | Aa3 | | 897.25 | | 8.55 | |
| Pennsylvania power & light––8 1/2 2022 | A2 | | 955.66 | | 8.55 | |
| Industrials: | | | | | | |
| Johnson & Johnson––6 3/4 2023 | Aaa | | 860.24 | | 8.45 | % |
| Dillard’s Department Stores––7 3/8 2023 | A2 | | 920.92 | | 9.00 | |
| Marriott Corp.––10 2015 | B2 | | 1,065.10 | | 9.66 | |
| a. | Compute the cost of debt, Kd (use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) |
| b. | Compute the cost of preferred stock, Kp. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) |
| Cost of preferred stock | % |
| c. | Compute the cost of common equity in the form of retained earnings, Ke. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) |
| d. | Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) |
| | Weighted Cost |
| Debt (Kd) | % |
| Preferred stock (Kp) | |
| Common equity (Ke) | |
| |
| Weighted average cost of capital (Ka) | % |
| |
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