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 10.5 percent coupon rate and another bond with an 8.1 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 11.4 percent. The common stock has a price of $59 and an expected dividend (D₁) of $1.79 per share. The historical growth pattern (g) for dividends is as follows:

$	1.34
	1.48
	1.63
	1.79

The preferred stock is selling at $79 per share and pays a dividend of $7.50 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 20 percent debt, 10 percent preferred stock, and 70 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.

Answer 1

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Solution

a)

Growth Rate = (1.79/1.34)^(1/3) -1

Growth Rate = 10.13%

b)

After tax Cost of Capital Debt (Kd) = 11.40 *(1-30%)

After tax Cost of Capital Debt (Kd) = 7.98%

Preferred stock (Kp) = Dividend/(Share price - flotation cost)

Preferred stock (Kp) = 7.50/(79-2%*79)

Preferred stock (Kp) = 9.69%

Common equity (Ke) = expected dividend/current share price + g

Common equity (Ke) = 1.79/59 + 10.13%

Common equity (Ke) = 13.16%

c)

Weighted Cost Debt (Kd) = Weight of debt * After tax Cost of Capital Debt (Kd)

Weighted Cost Debt (Kd) = 20%*7.98

Weighted Cost Debt (Kd) = 1.596%

Weighted Preferred stock (Kp) = Weight of Preferred stock (Kp) * cost of Preferred stock (Kp)

Weighted Preferred stock (Kp) = 10%*9.69%

Weighted Preferred stock (Kp) = 0.97%

Weighted  Common equity (Ke) = Weight of Common equity (Ke) * cost of Common equity (Ke)

Weighted Common equity (Ke) = 70%*13.16%

Weighted Common equity (Ke) = 9.21%

Weighted average cost of capital (Ka) = Weighted Cost Debt (Kd) + Weighted Preferred stock (Kp) + Weighted Common equity (Ke)

Weighted average cost of capital (Ka) = 1.596 +0.97 + 9.21

Weighted average cost of capital (Ka) = 11.78%