As a member of the Finance Dept. of Ranch Manufacturing, your supervisor has ask

Question

As a member of the Finance Dept. of Ranch Manufacturing, your supervisor has asked you to compute the appropriate discount rate to use when evaluating the purchase of new packaging equipment for the plant. Under the assumption that the firm's present capital structure reflects the appropriate mix of capital sources fro the firm, you have determined the market value of the firm's capital structure as follows: Source of Capital Market Values Bonds $4,500,000 Preferred stock $2,100,000 Common stock $5,600,000 To finance the purchase, Ranch Manufacturing will sell 10 year bonds paying 7.2% per year at the mart price of $1067. Preferred stock paying a $1.94 dividend can be sold for $24.17. Common stock for Ranch Manufacturing is currently selling for $54.12 and the firm paid $3.02 dividend last year. Divedends are expected to grow at a rate of 5.2% per year into the indefinite future. If the firm tax rate is 30% what discount rate should you use to evaluate the equipment purchase

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Step 1: Calculate Cost of Debt:

PMT = 1000*7.2% = 72 (indicates annual interest payment)

FV = 1000 (indicates the face value of bonds)

PV = 1067 (indicates the current selling price)

Nper = 10 (indicates the period)

After Tax Cost of Debt = Rate(Nper,PMT,PV,FV)*(1-Tax Rate) = Rate(10,72,-1067,1000)*(1-30%) = 4.394%

Step 2: Calculate Cost of Preferred Stock:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 = 1.94/24.17*100 = 8.026%

Step 3: Calculate Cost of Common Stock:

Cost of Common Stock = D1/Current Stock Price + Growth Rate = 3.02*(1+.052)/54.12 + .052 = 11.070%

Step 4: Calculate Discount Rate:

Discount Rate = After Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity = 4.394*4500000/(4500000 + 2100000 + 5600000) + 8.026*2100000/(4500000 + 2100000 + 5600000) + 11.070*5600000/(4500000 + 2100000 + 5600000) = 8.084% or 8.08%

Answer is 8.084% or 8.08%.

Thanks.

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