Question

Pacific Desert Corp is considering a large investment in bio-fuel algae. For this new project the company has determined that its optimal capital budget can be externally financed with $70 million of 10 percent first-mortgage bonds sold at par and $14 million of preferred stock costing the company 11 percent. The remainder of the capital budget will be financed with common stock, which is presently selling at $25 a share, and next year's common dividend, Di, is expected to be $2 a share. The company will issue 2.24 million common shares. The company's past annual growth rate in dividends and earnings has been 6 percent. However, a 5 percent annual growth in earnings and dividends is expected for the foreseeable future. The company's marginal tax rate is 40 percent. Calculate the company's weighted average cost of capital.

Answer 1

As debt is issued at par, the cost of debt=coupon rate=10%

WACC=(Debt*cost of debt*(1-tax rate)+Preferred stock*cost of preferred stock+Price per share*Number of shares*(D1/P0+g))/(Debt+Preferred stock+Price per share*Number of shares)

=(70*(10%*(1-40%))+14*(11%)+25*2.24*(2/25+5%))/(70+14+25*2.24)
=9.30%