Problem 11 26 Impact of credit ratings on cost of capital LO11 3 Northwest Utility Company faces increasing needs for capital Fortunately, it has an Aa3 credit rating The corporate tax rate is 40 percent Northwests treasurer is trying to determine the corporations current weighted average cost of capital in order to assess the profitability of capital budgeting projects Historically, the corporations earnings and dividends per share have increased about 6 4 percent annually and this should continue in the future Northwests common stock is selling at $73 per share, and the company will pay a $4 60 per share dividend (D 1 ) The companys $114 preferred stock has been yielding 10 percent in the current market Flotation costs for the company have been estimated by its investment banker to be $8 00 for preferred stock The companys optimal capital structure is 60 percent debt, 25 percent preferred stock, and 15 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 Moodys Rating Price Yield to Maturity Utilities Southwest electric power7 1 4 2023 Aa2 $ 940 18 8 35 Pacific bell7 3 8 2025 Aa3 900 25 8 88 Pennsylvania power light8 1 2 2022 A2 970 66 8 88 Industrials Johnson Johnson6 3 4 2023 Aaa 890 24 8 66 Dillards Department Stores7 3 8 2023 A2 950 92 8 66 Marriott Corp 10 2015 B2 1,080 10 9 55 a Compute the cost of debt, K d (use the accompanying tablerelate to the utility bond credit rating for yield ) (Do not round intermediate calculations Input your answer as a percent rounded to 2 decimal places ) cost of debt b Compute the cost of preferred stock, K p (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, K e (Do not round intermediate calculations Input your answer as a percent rounded to 2 decimal places ) cost of common equity 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 ) debt preferred stock common equity weighted average cost of capital

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Problem 11-26 Impact of credit ratings on cost of capital [LO11-3] Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit

Problem 11-26 Impact of credit ratings on cost of capital [LO11-3]

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwests treasurer is trying to determine the corporations current weighted average cost of capital in order to assess the profitability of capital budgeting projects. Historically, the corporations earnings and dividends per share have increased about 6.4 percent annually and this should continue in the future. Northwests common stock is selling at $73 per share, and the company will pay a $4.60 per share dividend (D₁). The companys $114 preferred stock has been yielding 10 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $8.00 for preferred stock.

The companys optimal capital structure is 60 percent debt, 25 percent preferred stock, and 15 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	Moodys Rating		Price	Yield to Maturity
Utilities:
Southwest electric power7 1/4 2023	Aa2	$	940.18		8.35	%
Pacific bell7 3/8 2025	Aa3		900.25		8.88
Pennsylvania power & light8 1/2 2022	A2		970.66		8.88
Industrials:
Johnson & Johnson6 3/4 2023	Aaa		890.24		8.66	%
Dillards Department Stores7 3/8 2023	A2		950.92		8.66
Marriott Corp.10 2015	B2		1,080.10		9.55

a. Compute the cost of debt, K_d (use the accompanying tablerelate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

cost of debt__________%

b. Compute the cost of preferred stock, K_p. (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, K_e. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) cost of common equity_________%

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.) debt______%

preferred stock_________

common equity_________

weighted average cost of capital________%