Question

McNabb Construction Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr. Reid, 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 an outstanding bond with a 9.5 percent coupon rate and another bond with a 7.8 percent rate. The firm has been informed by its investment dealer that bonds of equal risk and credit ratings are now selling to yield 10.5 percent. The common stock has a price of $98.44 and an expected dividend(D₁) of $3.15 per share. The historical growth pattern (g) for dividends is as follows:

   

	$2.00
	2.24
	2.51
	2.81

The preferred stock is selling at $90 per share and pays a dividend of $8.50 per share. The corporate tax rate is 30 percent. The flotation cost is 2 percent of the selling price for preferred stock. The optimum capital structure for the firm is 30 percent debt, 10 percent preferred stock, and 60 percent common equity in the form of retained earnings.

a. Compute the historical growth rate.(Round your intermediate calculations to 2 decimal places. Round the final to 2 decimal places.)

b. Compute the cost of capital for the individual components in the capital structure. (Round growth rate to nearest whole number. Round the final answers to 2 decimal places.)

Debt (Kd)	7.35 7.35 Correct %
Preferred stock (Kp)	9.64 9.64 Correct
Common equity (Ke

c. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Round your intermediate calculations to 2 decimal places. Round the final answers to 2 decimal places.)

Debt (Kd)	2.21 2.21 Correct %
Preferred stock (Kp)	0.96 0.96 Correct
Common equity (Ke)	7.32 7.32 Incorrect
Weighted average cost of capital(Ka)	10.49 10.49 Incorrect %

Answer 1

Question a)

For the dividends, the following equation can be formed

Last dividend = Dividend 3 years before last dividend x (1 + Growth)³

So, substituting the values in the formula, we get

2.81 = 2 x (1 + Growth)³

Growth Rate = 12%

Question b)

Cost of debt
= Bond YTM x (100 - Tax)
= 10.5% x 70%
= 7.35%

Cost of preferred stock
= Dividend / (Price - Flotation cost)
= $8.50 / ($90 x 98%)
= 9.64%

Cost of common stock
= Expected dividend / Current price + Growth
= $3.15 / $98.44 + 0.12
= 15.2%

Question c)

WACC
= Sum of (Weights x Costs)
= 7.35% x 30% + 9.64% x 10% + 15.2% x 60%
= 12.289%