As a member of the Finance department of Ranch Manufacturing, your superviosr ha

Question

As a member of the Finance department of Ranch Manufacturing, your superviosr has asked you to compute the appropriate discount rate to use when evaluation the purchase of a new packaging equiptment 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 sturcute is as follows:

Source of capital                                      Market Values

Bonds                                                       4,000,000       

Preferred Stock                                        1,900,000

Common Stock                                         6,100,000

To finance the purchase Ranch Manufacturing will sell 10-year bonds paying 7.2% per year at themarket price of $1,037. Preferred stock paying a $2.07 dividend can be sold for $25.23. Common stock for Ranch Manufacturing is currently selling for $54.58 per share and the firm paid a $3.05dividend last year. Dividends are expected to continue growing at a rate of 5.3% per year into the indefinite future. If the firm's tax rate is 30%, what discount rate should you use to evaluate the euqipment purchase?

Explanation / Answer

Kp = 2.07/25.23 = 8.20%

Ke

54.58 = (3.05*1.053 )/(Ke - 0.053)

Ke =(3.21165/54.58) + 0.053 = 11.18%

Kd

1037 = 72PVIFA(YTM,10) + 1000PVIFA(YTM,10)

YTM = 6.68%

Post tax Kd = 6.68*0.70 = 4.68%

WACC = 4.68*40/120 + 11.18*61/120 + 8.20*19/120 = 8.54%

what discount rate should you use to evaluate the euqipment purchase

Discount rate should be used = 8.54%

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