Question

A-Rod Manufacturing Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr. Jeter, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with a 10.3 percent coupon rate and another bond with an 7.9 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 11.2 percent. The common stock has a price of $57 and an expected dividend (D₁) of $1.77 per share. The historical growth pattern (g) for dividends is as follows:

$	1.32
	1.46
	1.61
	1.77

The preferred stock is selling at $77 per share and pays a dividend of $7.30 per share. The corporate tax rate is 30 percent. The flotation cost is 3.0 percent of the selling price for preferred stock. The optimal capital structure for the firm is 25 percent debt, 15 percent preferred stock, and 60 percent common equity in the form of retained earnings.

a. Compute the historical growth rate. (Do not round intermediate calculations. Round your answer to the nearest whole percent and use this value as g. Input your answer as a whole percent.)

	Growth rate    %

b. Compute the cost of capital for the individual components in the capital structure. (Use the rounded whole percent computed in part a for g. Do not round any other intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

	Weighted Cost Debt % Preferred stock Common equity

c. Calculate the weighted cost of each source of capital and the weighted average cost of capital.

	Weighted Cost Debt % Preferred stock Common equity Weighted average cost of capital %

Answer 1

a) Historical dividend growth rate :

Year 1 growth = ($1.46 - $1.32)/$1.32 = 0.1061 or 10.61%

Year 2 growth = ($1.61 - $1.46)/$1.46 = 0.1027 or 10.27%

Year 3 growth = ($1.77 - @1.61)/$1.61 = 0.0994 or 9.94%

Average growth rate = (10.61% + 10.27% + 9.94%) / 3 years

Average growth rate = 10.27%

b) i) Cost of debt = YTM * (1 - Tax rate)

YTM = 11.20% or 0.1120

Tax rate = 30% or 0.30

Cost of debt = 0.1120 * (1 - 0.30)

Cost of debt = 0.0784 or 7.84%

ii) Cost of preferred stock = Preferred Dividend / (Price * (1 - Flotation rate))

Here, Flotation rate = 3% or 0.03

Preferred Dividend = $7.30

Price = $77

Now,

Cost of preferred stock = $7.30 / ($77 * (1 - 0.03))

Cost of preferred stock = $7.30 / $74.69

Cost of preferred stock = 0.0977 or 9.77%

iii) Cost of equity using retained earnings = (D1 / Price) + g

Here, D1 (Expected dividend) = $1.77

Price = $57

g (growth rate as calculated in part a) = 10.27% or 0.1027

Now,

Cost of retained earnings = ($1.77 / $57) + 0.1027

Cost of retained earnings = 0.1338 or 13.38%

c) WACC (Weighted average cost of capital) = (Weight of debt * Cost of debt) + (Weight of preferred stock) + (Weight of comment stock * Cost of equity using retained earnings)

Here,

Weight of debt = 25% or 0.25

Weight of preferred stock = 15% or 0.15

Weight of common stock = 60% or 0.60

Use the cost of capital calculated in part (b) above,

WACC = (0.25 * 0.0784) + (0.15 * 0.0977) + (0.60 * 0.1338)

WACC = 0.0196 + 0.0147 + 0.0803

WACC = 0.1146 or 11.46%