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 to use when evaluating hte 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 firms captial structure as follows:

Bonds 4,100,000

Preferred Stock 2,100,000

Common Stock 6,500,000

To Finance the purchase, Ranch Manufacturing will sell 10-year bonds paying 7.3% per year at the market price of $1,055. Preferred stock paying a $2.04 dividend can be sold for $24.49. Common Stock for Ranch Manufacturing is currently selling for $55.83 per share and the firm paid a $3.02 dividend last year. Dividend last year. Dividends are expected to continue growin at for Ranch Manufacturing is currently selling for $55.83 per share and the firm paid a $3.02 dividend last year. Dividends are expected to continue growing at a rate of 5.4% per year into the indefinite future. If the firms tax rate is 30%, what discount rate should you use to evaluate the equipment purchase?

Explanation / Answer

Hi,

Please find the answer as follows:

Cost of Debt = Rate(nper,pmt,pv,fv)

Nper = 10

PMT = 1000*.7.3% = 73

PV = -1055

FV = 1000

Cost of Debt = Rate(10,73,-1055,1000) = 6.53%

After Tax Cost of Debt = 6.53*(1-.30) = 4.57%

Cost of Equity = D1/Current Stock Price + g = 3.02*(1+.054)/55.83 + .054 = 11.10%

Cost of Preferred Stock = Preferred Dividend/Stock Price*100 = 2.04/24.49*100= 8.33%

Weighted Average Cost of Capital = Weight of Debt*After Tax Cost of Debt + Weight of Equity*Cost of Equity + Weight of Preferred Stock*Cost of Preferred Stock

WACC = 4100000/(4100000 + 2100000 + 6500000)*4.57% + 2100000/(4100000 + 2100000 + 6500000)*8.83 + 6500000/(4100000 + 2100000 + 6500000)*11.10 = 7.156%

Answer is 9.25%

Thanks.

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