Question

---Jeremy Publishing Company is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. Mouthwash, the vice-president of finance, has given you the following information and asked you to compute the weighted average cost of capital.

 

The company currently has outstanding a bond with an 6.0 percent coupon rate and a convertible bond with a 3.0 percent rate. The firm has been informed by its investment dealer, John Travolta, and Company, that bonds of equal risk and credit rating are now selling to yield 7.0 percent. The common stock has a price of $88.0 and an expected dividend (D₁) of $5.60 per share. The firm’s historical growth rate of earnings and dividends per share has been 8.0 percent, but security analysts on South Street expect this growth to slow to 12 percent in the future. The preferred stock is selling at $84 per share and carries a dividend of $8.20 per share. The corporate tax rate is 35 percent. The flotation costs are 3 percent of the selling price for preferred stock.

 

The optimum capital structure for the firm seems to be 40 percent debt, 40 percent preferred stock, and 20 percent common equity in the form of retained earnings.

 

a. Compute the cost of capital for the individual components in the capital structure. (Round the final answers to 2 decimal places.)

 

	Cost of capital
Debt (Kd)	%
Preferred stock (Kp)
Common equity (Ke)

 

b. Calculate the weighted average cost of capital. (Round intermediate calculations to 2 decimal places. Round the final answers to 2 decimal places.)

 

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

Answer 1

Market Market value value weights WACC (Cost %xWeights) Cost % Common equity 20 0.20 2.87% a) Debt 4.55% 14.36% $ =5.6/88+8% Preferred stock 10.06% Debt 4.55% $ 40 0.40 1.82% =7%*(1-35%) Common equity 14.36% Preferred stock 10.06% $ 40 0.40 4.03% b) Debt Preferred stock =8.2/(84*(1-3%)) 1.82% 4.03% 2.87% 8.72% Common equity WACC Total $ 100 1.00 Weighted average cost of capital (WACC) 8.72%