Zizig Company Limited (ZCL) is a listed company involved in agriculture. Its current land and processing plant are too small to meet the growing demand that it anticipates to have once it gets a permit for the construction of a new dam. It therefore seeks to expand its operations and is wary of a discount rate it can use as a hurdle rate in its decision making. To estimate this rate, they have been advised to consider estimating the weighted average cost of capital as a basis for identifying this hurdle rate. The following information is available. The current capital structure is shown below:
Debt, 9% coupon, K1,000 par K20,000,000
Preferred stock, 8% dividend,K50 K10,000,000
Common stock, K1 par K2,000,000
Retained earnings K68,000,000
TOTAL K100,000,000
New K1,000 par bonds can be sold at par with a 10% coupon. New K25 par Preferred stock may be sold at par with a k2.50 dividend per share. Dividends on the common stock have grown at a rate of 8% which is expected to continue. Next year’s dividend is expected to be K2.00 per share and the company’s common stock whose beta coefficient is 1.5, currently sells over-the –counter at K20.00 per share. The risk free rate is 6% and the return on the market portfolio is 15%. The company is in the 35% tax bracket.
Required: (i) Calculate the cost of debt for ZCL.
(ii) Calculate the company’s cost of preferred stock.
(iii) Calculate the cost of equity using both the dividend growth model and the security market line.
(iv) What is the firm’s weighted average cost of capital?
(v) Explain why many companies use their weighted average cost of capital (WACC) to evaluate capital investments, and what particular assumptions they make in using WACC for this purpose.