MacLeod Manufacturing Company is trying to calculate its cost of capital for use

Question

MacLeod

Manufacturing Company is trying to calculate its cost of capital

for use in making capital budgeting decisions. Mr.

Bailey, 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 10.6% coupon rate and another bond with

an 8.2% coupon rate. The firm as been informed by its

investment banker that bonds of equal risk and credit rating are

now selling to yield 11.5%. The common stock has a

price of $60 and an expected dividend of $1.95 per

share. The last four per share dividends paid by the

company have been $1.80, $1.64, $1.49, and $1.35. The

preferred stock is selling for $80 per share and pays a dividend of

$7.60 per share. The corporate tax rate is 30%, and

the target (or optimal) capital structure is 25% debt, 10%

preferred stock, and 65% common stock. What is

MacLeod's weighted average cost of capital?

Explanation / Answer

Kd = Yield (1 – T)
= 11.5% (1 – .30) = 11.5% (.70) = 8.05%
Kp = Dp/(Pp – F)
= $7.60/($80.00 – $2.00) = $7.60/$78.00 = 9.74%
Ke = (D1/P0) + g
D1 = $1.95
P0 = $60

a. g = 10% (see below)
$.14/1.35 = 10.3%
.15/1.49 = 10.1%
.16/1.64 = 9.8%
Round to 10% or = $1.64/1.35 n=3 FVIF = 1.331
g = 10%

b.
Ke = (D1/P0) + g
= $1.95/$60 + 10% = 3.25% + 10% = 13.25%
Debt (Kd)= 8.05%
Preferred stock (Kp)= 9.74%

c.
Weighted average cost of capital (Ka)= 11.599%
13.25x.65+(8.05x.25)+(9.74x.1)= 11.599%

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