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 10.2 percent coupon rate and another bond with an 7.8 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 11.1 percent. The common stock has a price of $56 and an expected dividend (D₁) of $1.76 per share. The historical growth pattern (g) for dividends is as follows:

$	1.31
	1.45
	1.60
	1.76

The preferred stock is selling at $76 per share and pays a dividend of $7.20 per share. The corporate tax rate is 30 percent. The flotation cost is 2.0 percent of the selling price for preferred stock. The optimum capital structure for the firm is 25 percent debt, 20 percent preferred stock, and 55 percent common equity in the form of retained earnings.

a. Compute the average 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.)

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.)

c. 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.)

Answer 1

Solution to part a:

Calculation of average historical growth rate:

Dividend Growth rate 1 = (1.45 - 1.31) / 1.31 = 10.69%

Dividend Growth rate 2 = (1.6 - 1.45) / 1.45 = 10.34%

Dividend Growth rate 3 = (1.76 - 1.6) / 1.6 = 10%

Average Dividend Growth Rate = (10.69% + 10.34% + 10%) / 3 = 10% (Rounded)

Solution to part b:

Cost of debt (Kd) = yield of similar bonds x (1 - tax rate)

= 11.1 % x (1 - 0.30)

= 7.77%

Cost of preferred stock = dividend per share / net proceeds per share

Dividend per share = $ 7.20

Net proceeds per share = price per share - (price per share * flotation cost)

= $ 76 - ( $ 76 * 2%)

= $ 74.48

Cost of preferred stock = $ 7.2 / $ 74.48 = 9.67%

Cost of Equity = (D1 / P0) + G

where D1 is the expected dividend at time 1 and  P0 = current share price, and G = growth rate

Cost of Equity = ($ 1.76 / $ 56) + 10%

= 13.14%

Solution to part c:

	Cost (as computed above)	Weights (as given)	Weighted Cost
Common Equity	13.14%	55%	7.23%
Preferred stock	9.67%	20%	1.93%
Debt	7.77%	25%	1.94%
Weighted average cost of capital			11.1%