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 11.3 percent coupon rate and another bond with an 8.9 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 12.2 percent. The common stock has a price of $67 and an expected dividend (D₁) of $1.87 per share. The historical growth pattern (g) for dividends is as follows:

 

$1.42 1.56 1.71 1.87

The preferred stock is selling at $87 per share and pays a dividend of $8.30 per share. The corporate tax rate is 30 percent. The flotation cost is 3.0 percent of the selling price for preferred stock. The optimal capital structure for the firm is 30 percent debt, 10 percent preferred stock, and 60 percent common equity in the form of retained earnings.

a. Compute the historical growth rate. 

Answer 1

a. Historical growth rate: We know that FV = PV(1+r)^n. Thus 1.87 = 1.42(1+r)^3

or r = 9.61%

Next we compute the cost of debt. Cost of debt = yield*(1-tax rate) = 12.2%*(1-30%) = 8.54%

Next step is to compute the cost of preferred stock. Kp = Dp/(Pp-F)

= 8.3/(87 - 3% of 87)

= 9.84%

Next step is computation of cost of equity.

Ke = D1/P0 + g

D1 = 1.87, P0 = $67 and g = 9.61%. Thus Ke = 1.87/60 + 9.61%

= 12.73%

Thus weighted cost of capital = weight of debt*after tax cost of debt + weight of preferred stock*cost of preferred stock + weight of equity*cost of equity

= 0.3*8.54% + 0.1*9.84% + 0.6*12.73%

= 11.18%