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 10.9 percent coupon rate and another bond with an 8.5 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now seling to yield 118 percent. The common stock has a price of $63 and an expected dividend (0) of $1.83 per share. The historical growth pattern (g) for dividends is as follows: $1.38 The preferred stock is selling at $83 per share and pays a dividend of $7.90 per share. The corporate tax rate is 30 percent. The flotation cost is 20 percent of the selling price for preferred stock. The optimal capital structure for the firm i 25 percent debt, 15 percent preferred stock and 60 percent common equity in the form of retained earings a. Compute the historical growth rate (Do not found intermediate calculations. Round your answer to the nearest whole percent and use this value os g. Input your answer as a whole percent.) Growth rate b. Compute the cost of capital for the individual components in the capital structure. Use the rounded whole percent answers as a percent rounded to 2 decimal places) o not round any other intermediate calculations, Input your Weighted Cost c. calculate the weighted cost of each source of capital and the weighted average cost of capital (Do not to decimal places.) Weighted Cost Wegd average cost of capital

Answer 1

a]

The dividend has grown from $1.38 to $1.83 in 4 years.

Ending dividend = beginning dividend * (1 + growth rate)^{number of years}

$1.83 = $1.38 * (1 + growth rate)⁴

growth rate = ($1.83 / $1.38)^1/4 - 1

growth rate = 7%

b]

cost of debt = yield of similar bonds * (1 - tax rate)

cost of debt = 11.8% * (1 - 30%)

cost of debt = 8.26%

cost of equity = (D₁ / P₀) + g,

where P₀ = current share price, and g = growth rate.

cost of equity = ($1.83 / $63) + 7%

cost of equity = 9.90%

cost of preferred stock = (dividend per share / net proceeds per share)

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

net proceeds per share = $83 - ($83 * 2%) = $81.34

cost of preferred stock = ($7.90 / $81.34)

cost of preferred stock = 9.71%

c]

weighted cost of debt = cost of debt * weight of debt

weighted cost of debt = 8.26% * 25% = 2.07%

weighted cost of equity = cost of equity * weight of equity

weighted cost of equity = 9.90% * 60% = 5.94%

weighted cost of preferred stock = cost of preferred stock * weight of preferred stock

weighted cost of preferred stock = 9.71% * 15% = 1.46%

WACC = 2.07% + 5.94% + 1.46%

WACC = 9.46%