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Credit ratings on cost of capital of First Tennessee Utility

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First Tennessee Utility Company faces increasing needs for capital. Fortunately, it has an Aa2 credit rating. The corporate tax rate is 36 percent. First Tennessee'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 at about a 6 percent annual rate.

First Tennessee's common stock is selling at $60 per share, and the company will pay a $4.80 per share dividend (D1). The company's $100 preferred stock has been yielding 9 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $1.50 for preferred stock. The company's optimum capital structure is 40 percent debt, 10 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 risk to First Tennessee. Compute the answers to questions a, b, c, and d on page 338 from the information given.

Data on Bond Issues

Issue Moody's Rating Price Yield to Maturity
Utilities:
Balt, G&E 83/8s 2010
Aa1 $ 975.25 8.60%
New York Tel. Co. Aa2 850.75 9.11
71/2s 2009

Miss. Pow. 9.62s
2011 A1 960.50 9.67

Industrials:
IBM 93/8s 2016 Aaa $ 1, 050.50 8.50%

May Dept. St. 7.95s 2010 Aa3 940.00 11.81

General Mills 93/8s
2009 A2 1, 030.75 9.05
a) Cost of debt, Kd. (Use the table on the prior page?relate to the utility bond credit rating for yield.)
b) Cost of preferred stock, Kp.
c) Cost of common equity in the form of retained earnings, Ke.
d) Weighted average cost of capital.

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First Tennessee Utility Company faces increasing needs for capital. Fortunately, it has an Aa2 credit rating. The corporate tax rate is 36 percent. First Tennessee'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 at about a 6 percent annual rate.

First Tennessee's common stock is selling at $60 per share, and the company will pay a $4.80 per share dividend (D1). The company's $100 preferred stock has been yielding 9 percent in the current market. Flotation costs for the ...

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