As a membe of the finance department of Ranch Manufacturing, your supervisor has

Question

As a membe of the finance department 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 for the firm, you have determined the market value of the firm's capital structure as follows:

Source of Capital                            Market Values

Bonds                                                $4,300,000

Preferred Stock                                $1,800,000

Common stock                                $ 6,400,000  

To finance the purchse Ranch Manufacturing, will sell 10 year bonds paying 7.1% per year at the market price of $1,035. Preferred stock paying a $2.07 dividend can be sold for $24.72. Common stock for Ranch Manufacturing  is currently selling for $54.22 per share and the firm paid a $2.94 dividend last year. Dividends are expected to continue growing at a rate of 5.4% per year into the indefinite future. If the firm's tax rate is 30% what discount rate should you use to evaluate the equipment purchase?

Explanation / Answer

Calculation of Specific Cost:
1
Equity = D1/P0 + g = 2.94*(1+5.4%)/54.22 + 5.4% = 11.12%
2
Preference Share = D1/P0 = 2.07/24.72 = 8.37%
3
Cost of Debt = i%.
Hence, 1035 = 7.1%*1000*PVIFA(i%,10) + 1000*PVIF(i%,10)
Thus, i=6.61%.
After Tax Cost of Debt = 6.61%*(1-0.3) = 4.63%

WACC = Proportion of Each Fund*Specific Cost
= (4,300,000*4.63% + 1,800,000*8.37% + 6,400,000*11.12%)/(4,300,000 + 1,800,000 + 6,400,000)
= 8.49%

THUS, THE DISCOUNT RATE TO BE USED IS 8.49%

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