Valvano Publishing Company is trying to calculate its cost of capital for use in a capital budgeting decision. Mr. Washburn, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.
The company currently has outstanding a bond with an 11 percent coupon rate and a convertible bond with an 7.1 percent rate. The firm has been informed by its investment dealer, Dean, Smith, and Company, that bonds of equal risk and credit rating are now selling to yield 13 percent. The common stock has a price of $45 and an expected dividend (D1) of $2.52 per share. The firm’s his- torical growth rate of earnings and dividends per share has been 14.5 percent, but security analysts on Bay Street expect this growth to slow to 11 percent in the future. The preferred stock is selling at $50 per share and carries a dividend of $5.50 per share. The corporate tax rate is 34 percent. The flotation costs are 3 percent of the selling price for preferred stock.
The optimum capital structure for the firm seems to be 35 percent debt, 10 percent preferred stock, and 55 percent common equity in the form of retained earnings.
Compute the cost of capital for the individual components in the capital structure, and then calculate the weighted average cost of capital.