Cost of Capital
Based on the information below calculate the cost of capital for Rio Tinto and state two reasons for why it may have declined since the GFC. Justify your answers using theory, calculations and research into current events.
In the years before the global financial crisis, Rio Tinto has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Rio Tinto's cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:
(1) The firm's tax rate is 30%.
(2) The current price of Rio Tinto's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Rio Tinto does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
(3) The current price of the firm's 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Rio Tinto would incur flotation costs equal to 5% of the proceeds on a new issue.
(4) Assume Rio Tinto's last annual dividend (D0) was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Rio Tinto's beta is 1.2, the yield on government bonds is 5.6%, and the market risk premium is estimated to be 6%.
(5) Rio Tinto's target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
(6) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future.