3) WACC labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. the weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity(retained earnings, new common stock, or both).the firm’s tax rate is 40%
Debt: the firm can sell bonds for $980 a 10-year, 1000 par value bond paying annual interest at a 10% coupon rate. a floatation cost of 3% of the par value is required in addition to the discount of $20 per bond.
Preferred Stock: 8% (annual dividend) preferred stock having a par value of 0 can be sold for $65. an additional fee of $2 per share must be paid to the underwriters.
Common Stock: the firm’s common stock is currently selling for $50 per share. the dividend payments, which have been approximately 60% of earnings per share in each of the past 5years, are shown in the following table.
2009 $ 3.75
it is expected to attract buyers, new common stock must be under priced $5 per share, and the firm must also pay $3 per share in floatation cost. dividend payments are expected to continue at 60% of earnings.
a) calculate the specific cost of each source of financing. assuming that the required return of retained earnings is equal to that of common stock.
b) if earning available to common shareholders are expected to be $7 million what s the break point associated with the exhaustion of retained earnings?
c) determine the average weighted average cost of capital between zero and the break point calculated in part b
d) determine the weighted average cost of capital just beyond the break point calculated in part b
Question 5 (Dividend Policy)
General Communications Company (GCC) is a fast growing internet access provider that initially went public in early 2003. its revenue growth and profitability have steadily risen since the firm’s inception in late 2001. GCC’s growth has been financed through the initial common stock offering, the sale of bonds in 2006, and the retention of all earnings. Because of its rapid growth in revenue and profits, with only short term earnings declines, GCC’s common stock holders have been content to let the firm reinvest earnings as part of its plan to expand capacity to meet growing demand for its services. this strategy has benefited most stock holders in terms of stock splits and capital gains. since the company’s initial public offering (IPO) in 2003, GCC’s stock twice has split 2-for-1. in terms of total growth, the market price of GCC’s stock. after adjustment for stock splits, has increased by 800% during the 7year period 2003-2009.
Because GCC’s rapid growth is beginning to slow, the firm’s CEO, Marilyn McNeely, believes that its shares are becoming less attractive to investors. McNeely had to discuss with he CFO , James Cook, who believes that the firm must begin to pay cash dividends. He argues that many investors value regular dividends and that by beginning to pay them, GCC would increase the demand and therefore, the price of its shares. McNeely decides that at the next board meeting she would propose that the firm begin to pay dividends on a regular basis.
McNeely realized that if the board approved her recommendation, it would have to 1) establish a dividend policy, and (2) set the amount of initial annual dividend. she had James cook prepare a summary of the firm’s annual EPS since it went public. the summary is in the table below.
James indicated that he expects EPS to remain with 10% (plus or minus) of the most recent (2009) value during the next 3years. His most likely estimate is an annual increase of 3%.
after discussion, McNeely and James agreed that she would recommend the board one of the following types of dividend policies:
a) constant-payout-ratio dividend policy- a certain percentage of earning
b) regular dividend policy – a fixed dollar amount each period
c) low -regular and extra dividend policy- a low regular dividend with supplemental payments when earnings are high.
Ms. McNeely realizes that her dividend policy could significantly affect future financing opportunities, cost and the firm’s share price. she also knows that she must be sure that her proposal is complete and that it fully educates the board with regard to the long-term implications of each policy.
1) Comment on each dividend policy after considering GCC’s financial position
2) which dividend policy would you recommend? support your recommendation
3) what are the key factors to consider when setting the amount of a firm’s initial annual dividend
4) how should Ms McNeely go about deciding what initial annual dividend she will recommend to the board?
5) in view of your dividend policy recommendation in part (b), how large an annual dividend would you recommend? support your recommendation
Note:it has to be completed in excel