Item 7

Western Electric Utility Company faces increasing needs for capital. Fortunately, it has an A (low) credit rating. The corporate tax rate is 35 percent. Westerns treasurer is trying to determine the corporations current weighted average cost of capital to assess the profitability of capital budgeting projects. Historically, the corporations earnings and dividends per share have increased at about a 8.4 percent annual rate.

Western Electrics common stock is selling at $75 per share, and the company will pay a $8.60 per share dividend (D1). The companys $118 preferred stock has been yielding 8 percent in the current market. Flotation costs for the company have been estimated by its investment dealer to be $3.00 for preferred stock. The companys optimum capital structure is 35 percent debt, 15 percent preferred stock, and 50 percent common equity in the form of retained earnings. Refer to the table below on bond issues for comparative yields on bonds of equal risks to Western Electric, maturing in 2038.

Data on Bond Issues

Issue

Rating Price Yield

to

Maturity

Utilities:

Valnet 6.17,2037 BBB (high) 99.66 6.75

Transcanada 6.65 2038 A (low) 103.88 4.47

West Coast Energy 6.03 2039 A (high) 100.26 6.92

Industrials:

Manulife Financial 5.90 2036 BBB 99.96 6.64

Dillard's Departmental Store 5.39 2037 A(low) 96.13 6.97

a. Compute the cost of debt, Kd. (Input your answer as a percent rounded to 2 decimal places.)

Cost of debt

%

b. Compute the cost of preferred stock, Kp. (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. (Input your answer as a percent rounded to 2 decimal places.)

Cost of common equity

%

d. Compute the weighted average cost of capital. (Input your answer as a percent rounded to 2 decimal places.)

Weighted Cost

Debt (Kd)

%

Preferred stock (Kp)

%

Common equity (Ke)

%

Weighted average cost of capital (Ka)

%