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 11.5 percent coupon rate and another bond with an 9.1 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 12.4 percent. The common stock has a price of $69 and an expected dividend (D1) of $1.89 per share. The historical growth pattern (g) for dividends is as follows:
$ | 1.44 |
1.58 | |
1.73 | |
1.89 |
The preferred stock is selling at $89 per share and pays a dividend
of $8.50 per share. The corporate tax rate is 30 percent. The
flotation cost is 2.0 percent of the selling price for preferred
stock. The optimal capital structure for the firm is 25 percent
debt, 20 percent preferred stock, and 55 percent common equity in
the form of retained earnings.
a. Compute the 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.)
b.
Compute the cost of capital for the individual components in the
capital structure. (Use the rounded whole percent computed
in part a for g. Do not round any other intermediate
calculations. Input your answers as a percent rounded to 2 decimal
places.)
c.
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.)
a
Annual average growth rate |
=((last value/First value)^(1/Time between 1st and last value)-1)*100 |
=((1.89/1.44)^(1/3)-1)*100 |
Annual Growth rate% = 9.5% |
b
As per DDM |
Price = Dividend in 1 year/(cost of equity - growth rate) |
69 = 1.89/ (Cost of equity - 0.095) |
Cost of equity% = 12.24 |
Cost of preferred equity = dividend/(price*(1-flotation cost)
=8.5/(89*(1-0.02))=9.75%
Cost of debt = current market rate*(1-tax rate) = 12.4*(1-0.3)= 8.68%
c
Weighted cost
equity:
=cost of equity*weight = 12.24*0.55= 6.73%
preferred equity:
cost of preferred equity*weight = 9.75*0.2= 1.95%
Debt :
cost of debt*weight = 8.68*0.25= 2.17%
WACC = sum of weighterd costs = 6.73+1.95+2.17=10.85%
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