As a member of the Finance Department of Ranch Manufacturing, your supervisor ha

Question

As a member of the Finance Department of Ranch Manufacturing, your supervisor has asked you to compute the appropriate discount rate of use when evaluating the purchase of new packing equipment for the plant. You have determined the market value of the firm's capital structure as follows: Source of Capital Market Values Bonds $3,600,000 Preferred Stock $1,500,000 Common Stock $6,300,000 To finance the purchase, Ranch Manufacturing will sell 10-year bonds paying 7.2% per year at the market price of $1031. Preferred Stock paying $2.03 dividend can be sold $25.58; Common Stock for Ranch Manufacturing is currently selling for $55.49 per share. The firm paid a $2.98 dividend last year and expects dividends to continue growing at a rate of 5.5% per year. The firm's tax rate is 30 percent. What is the WACC?

Explanation / Answer

Bonds - a 1,000 bond selling at 1,053, paying 6.8%, or 68 on 1,053 costs 6.46% before tax, less 30% tax, results in an after tax cost of 4.5%. Preferred stock pays a dividend of 2.04 on a market price of 25.99, or 7.8%. Common stock, selling at 55.39 with a constant growth rate of 4.7%, has an expected return of R based on the Gordon growth model, where R = Next Div/Price + G, or R = 3.15/55.39 + 4.7% = 10.4%. WACC, based on market values: Bonds - 36.0 mil @ 4.5% = 1,620,000 Preferred - 1.8 mil @ 7.8% = 140,400 Common - 6.0 mil @ 10.4% = 624,000 Total Cost of 2,384,400 on 43.8 mil = 5.4% WACC or - 82.2% costs 4.5%, or 3.7% 4.1% costs 7.8%, or .3% 13.7% costs 10.4%, or 1.4% 100.0% costs 5.4% WACC

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