To finanance a purchase a company will sell 10 year bonds paying 6.6% per year at the market price of $1062. Preferred stock paying a $2.05 dividend can be sold for 25.93. Common stock is cirrently seeling for 54.29 per share and the firm paid a 2.92 dividend last year. Dividends are expected to grow at a rate of 4.8% per year into the indefinite future. if the firms tax rate is 30%, what discount rate should you use to evaluate the equipment purchase? And what is the WACC?
To determine the discount rate that should be used to evaluate the equipment purchase and calculate the Weighted Average Cost of Capital (WACC), we need to calculate the cost of each component of the company's capital structure.
1. Bonds:
The interest rate on the bonds is 6.6% per year, which we can represent as 0.066 in decimal form. The market price of the bonds is $1,062. The formula to calculate the cost of debt is:
Cost of Debt = (Interest Payment / Market Price) * (1 - Tax Rate)
Interest Payment = Bond Interest Rate * Market Price
Interest Payment = 0.066 * $1,062 = $70.07
Cost of Debt = ($70.07 / $1,062) * (1 - 0.30) = 0.0424 or 4.24% (rounded to two decimal places)
2. Preferred Stock:
The preferred stock pays a dividend of $2.05 and is sold for $25.93. The formula to calculate the cost of preferred stock is:
Cost of Preferred Stock = Dividend / Stock Price
Cost of Preferred Stock = $2.05 / $25.93 = 0.079 or 7.9% (rounded to one decimal place)
3. Common Stock:
The common stock is currently selling for $54.29, and the firm paid a dividend of $2.92 last year. The expected dividend growth rate is 4.8% per year. To calculate the cost of common stock (equity), we use the Dividend Discount Model (DDM):
Cost of Common Stock = (Dividend / Stock Price) + Dividend Growth Rate
Cost of Common Stock = ($2.92 / $54.29) + 0.048 = 0.102 or 10.2% (rounded to one decimal place)
4. Weighted Average Cost of Capital (WACC):
The WACC is calculated by weighting the costs of each component of the capital structure by their proportionate weights. The formula for WACC is:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Preferred Stock * Cost of Preferred Stock) + (Weight of Common Stock * Cost of Common Stock)
To calculate the weights, we need to know the percentage of each component in the capital structure. Let's assume that the company has 40% debt, 20% preferred stock, and 40% common stock.
Weight of Debt = 0.4
Weight of Preferred Stock = 0.2
Weight of Common Stock = 0.4
Using these weights, we can calculate the WACC:
WACC = (0.4 * 0.0424) + (0.2 * 0.079) + (0.4 * 0.102) = 0.07796 or 7.796% (rounded to three decimal places)
Therefore, the discount rate to evaluate the equipment purchase should be 7.796% (WACC).