Question

(Weighted average cost of​ capital)  As a member of the Finance Department of Ranch​ Manufacturing, your supervisor has asked you to compute the appropriate discount rate to use when evaluating the purchase of new packaging equipment for the plant. Under the assumption that the​ firm's present capital structure reflects the appropriate mix of capital sources for the​ firm, you have determined the market value of the​ firm's capital structure as​ follows:

Source of Capital	Market Values
BONDS	$4,300,000
PREFERRED STOCK	$1,700,000
COMMON STOCK	$5,800,00

To finance the​ purchase, Ranch Manufacturing will sell 10​-year bonds paying interest at a rate of 7.5 percent per year​ (with semiannual​ payment) at the market price of ​$1,066. Preferred stock paying a ​$1.95 dividend can be sold for $24.21. Common stock for Ranch Manufacturing is currently selling for $54.48 per share and the firm paid a ​$3.03 dividend last year. Dividends are expected to continue growing at a rate of 5.4 percent per year into the indefinite future. If the​ firm's tax rate is 30 ​percent, what discount rate should you use to evaluate the equipment​ purchase?

a.  Calculate component weights of capital = __% (Round to two decimal places.)

b.  Calculate component costs of capital = __% (Round to two decimal places.)

c.  Calculate the​ firm's weighted average cost of capital = __% (Round to two decimal places.)

common stock * $5,800,000

Answer 1

a]	Component weights of capital:
	Component	Market Value	Component Weight
	Debt [Bonds]	$       43,00,000	36.44%
	Preferred stock	$       17,00,000	14.41%
	Common stock	$       58,00,000	49.15%
	Total	$   1,18,00,000	100.00%
b]	Cost of debt:
	Before tax cost of debt = YTM.
	YTM using an online calculator = 6.59%
	After tax cost of debt = YTM*(1-t) = 6.59%*(1-30%) =	4.61%
	Cost of preferred stock = 1.95/24.21 =	8.05%
	Cost of common stock [using constant dividend growth model] = Next expected dividend/Price+growth rate = 3.03*1.054/54.48+0.054 =	11.26%
c]	WACC is worked out in table below:
	Component	Market Value	Component Weight	Component Cost	WACC
	Debt [Bonds]	$       43,00,000	36.44%	4.61%	1.68%
	Preferred stock	$       17,00,000	14.41%	8.05%	1.16%
	Common stock	$       58,00,000	49.15%	11.26%	5.53%
	Total	$ 1,18,00,000	100.00%		8.37%
	WACC = 8.37%