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-1. 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.)

Growth rate = _____%

a-2. 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.)

Common equity = _______

a-3. 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.)

Common equity = _______

Answer 1

a)

Calculation of Growth Rate for each year as follows :

At $ 1.48 Dividend:

Growth Rate = $ 1.48 - $ 1.34 / $ 1.34

= $ 0.14 / $ 1.34

= 0.10447761194

= 10.447761194 %

At $ 1.63 Dividend:

Growth Rate = $ 1.63 - $ 1.48 / $ 1.48

= $ 0.15 / $ 1.48

= 0.10135135135135

= 10.135135135135 %

At $ 1.79 Dividend:

Growth Rate = $ 1.79 - $ 1.63 / $ 1.63

= $ 0.16 / $ 1.63

= 0.0981595092

= 9.8159502 %

Calculate the Average Historical Growth Rate as Follows:

Growth Rate = 10.447761194 % + 10.135135135135 % + 9.8159502 % / 3

= 30.398847249135 % / 3

= 10.132949083045 %

Therefore, the historical growth rate is 10.13%

b)

Calculation of after-tax cost of debt as follows:

After tax cost debt = Cost of debt * (1- tax rate)

= 11.4 % * (1- 0.30)

= 11.4 % * 0.70

= 7.98%

Therefore, the after-tax cost debt is 7.98%

Calculation of the flotation cost for preferred stock as follows:

Flotation cost for preferred stock = Selling Price * 2 %

= 79 * 2%

= $ 1.58

Calculation of Cost of preferred stock as follows:

Cost of preferred stock = Dividend / Preferred stock price - flotation cost

= $ 7.50 / $ 79 - $ 1.58

= $ 7.50/ $ 77.42

= 0.096874192715

= 9.6874192715 %

Therefore, the cost of preferred stock is 9.69%

Calculation of the cost of common equity as follows:

Cost of common stock = ( Expected Dividend / Stock Price ) + Growth Rate

= ( $ 1.79 / $ 59 ) + 10.132949083045%

= 0.0303389830508 + 0.10132949083045

= 0.13166847388125

= 13.166847388125 %

Therefore, the cost of common stock is 13.17 %

c)

Calculation of the Weighted cost of each source as follows:

Weighted Cost of Debt = Weight for debt * After-tax cost of debt

= 20 % 7.98 %

= 1.596 %

Weighted cost of preferred stock = Weight for preferred stock * Cost of preferred stock

= 10 % 9.6874192715 %

= 0.96874192715 %

Weighted cost of Common stock = Weight for Common stock * Cost of Common stock

= 70 % 13.166847388125 %

= 9.2167931716875 %

Calculation of WACC as follows:

WACC = Weight or debt * After the cost of debt + Weight for preferred stock * Cost of preferred stock

+ Weight for Common stock * Cost of Common stock

= (20 % 7.98 %) + (10 % 9.6874192715 %) + (70 % 13.166847388125 %)

= 1.596 % + 0.96874192715 % + 9.2167931716875 %

= 11.7815350988375 %

= 11.78 %

Therefore, WACC is 11.78 %