Problem:
The treasurer at Pendant, Inc. is estimating the company's weighted average cost of capital. Everyone in the company evaluating capital investments will use this estimate of WACC. The financial information is as follows:
The company's 6.5% coupon rate bonds pay annual interest, mature eight years from now and sell on the New York Bond Exchange for 92.50. The face value of the bond is 100. Pendant's common and preferred stock are listed on the New York Stock Exchange. The common stock is selling for 58.50 and pays a dividend of 2.20. Analysts expect growth of 6% per year. When Pendant sells common stock, it incurs a flotation cost (investment banking and administrative fees) of 4%, which reduces the amount it receives from selling each share by 4%. The preferred stock sells for 22.63 and carries a dividend of 1.89. Flotation costs are 3% when preferred stock is sold. Since preferred stockholders do not share in the growth of the company, the cost of preferred stock is just the dividend yield calculated based on a price net of flotation cost. The company's beta coefficient is .65. Its optimum financial structure, based on market values, consists of 40% debt, 2% preferred stock, 28% common stock and 30% retained earnings. The company's tax rate is 36%. When the company sells common stock to raise capital, it estimates the cost of common equity with the dividend yield plus percentage growth rate model. It estimates its cost of retained earnings with the Capital Asset Pricing Model (see formula 8.2, p.301 in the Higgins text), and assumes an interest rate on government bond of 5%, and an 8% historical excess return on common stocks. Calculate the company's WACC.