14-26 as a member of the finance Department of Ranch Manufacturing, your boss has asked you to compute the appropriate discount rate to use when evaluating the 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 firm’s capital structure as follows:
Source of capital Market value
Bonds $400, 000
Preference shares $2000, 000
Ordinary shares $6000, 000
To finance the purchase, Ranch Manufacturing will sell 10 –year bonds paying interest at a rate of 8% per year (with semi-annual payments) at the market price of $1050. Preference shares paying a $2.00,
dividend can be sold for $25. Ordinary shares for Ranch Manufacturing are currently selling for $55 each and the firm paid a $3 dividend last year.
Dividends are expected to continue growing at a rate of 5% per year into the indefinite future.
If the firm’s tax rate is 30%, what discount rate should you use to evaluate the equipment purchase?
as a member of the finance Department of Ranch Manufacturing, your boss has asked you to compute the appropriate discount rate to use when evaluating the 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 firm’s capital structure as follows:
Source of capital Market value
Bonds $400, 000
Preference shares $2000, 000
Ordinary shares $6000, 000
To finance the purchase, Ranch Manufacturing will sell 10 –year bonds paying interest at a rate of 8% per year (with semi-annual payments) at the market price of $1050. Preference shares paying a $2.00,
dividend can be sold for $25. Ordinary shares for Ranch Manufacturing are currently selling for $55 each and the firm paid a $3 dividend last year.
Dividends are expected to continue growing at a rate of 5% per year into the indefinite future.
If the firm’s tax rate is 30%, what discount rate should you use to evaluate the equipment purchase?
To determine the appropriate discount rate to use when evaluating the purchase of new packaging equipment for Ranch Manufacturing, we need to calculate the cost of each source of capital. Let's start by computing the cost of each capital source:
1. Cost of Bonds:
The market value of the bonds is given as $400,000. Since the bonds pay interest semi-annually, we need to adjust the interest rate accordingly. The annual interest rate is 8%, so the semi-annual interest rate is (8% / 2) = 4%.
The market price of the bonds is $1050. To calculate the annual coupon payment, we multiply the face value of the bonds by the semi-annual interest rate:
Coupon payment = Face value * Semi-annual interest rate = $1000 * 4% = $40
The cost of the bonds is the coupon payment divided by the market price of the bonds:
Cost of bonds = Coupon payment / Market price of bonds = $40 / $1050 ≈ 0.0381 or 3.81%
2. Cost of Preference Shares:
The market value of the preference shares is given as $2,000,000. The dividend payment per preference share is $2. The cost of preference shares is the dividend payment divided by the market price of preference shares:
Cost of preference shares = Dividend payment / Market price of preference shares = $2 / $25 = 0.08 or 8%
3. Cost of Ordinary Shares:
The market value of the ordinary shares is given as $6,000,000. The dividend paid last year was $3. The dividend growth rate is given as 5% per year. To calculate the dividend expected for the current year, we multiply the previous year's dividend by (1 + growth rate):
Dividend expected this year = Previous year's dividend * (1 + Growth rate) = $3 * (1 + 5%) = $3 * 1.05 = $3.15
The cost of ordinary shares can be calculated using the dividend discount model (DDM):
Cost of ordinary shares = Dividend expected this year / Market price of ordinary shares = $3.15 / $55 ≈ 0.057 or 5.7%
Next, we need to calculate the weighted average cost of capital (WACC) by weighting each cost of capital by the respective market value of the capital source:
WACC = (Weight of bonds * Cost of bonds) + (Weight of preference shares * Cost of preference shares) + (Weight of ordinary shares * Cost of ordinary shares)
To calculate the weights, we divide the market value of each capital source by the total market value of the firm's capital structure:
Weight of bonds = Market value of bonds / Total market value of capital structure
= $400,000 / ($400,000 + $2,000,000 + $6,000,000) ≈ 0.05 or 5%
Weight of preference shares = Market value of preference shares / Total market value of capital structure
= $2,000,000 / ($400,000 + $2,000,000 + $6,000,000) ≈ 0.25 or 25%
Weight of ordinary shares = Market value of ordinary shares / Total market value of capital structure
= $6,000,000 / ($400,000 + $2,000,000 + $6,000,000) ≈ 0.75 or 75%
Now we can calculate the WACC:
WACC = (0.05 * 3.81%) + (0.25 * 8%) + (0.75 * 5.7%)
Finally, we multiply the WACC by (1 - Tax rate) to account for the tax advantage of debt financing:
Discount rate = WACC * (1 - Tax rate)
Substituting the given tax rate of 30%:
Discount rate = WACC * (1 - 0.30)
Now you can calculate the discount rate by substituting the values calculated above into the equation.