(Weighted average cost of capital) 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
Bonds Preference shares Ordinary shares
Market values
$4000000 $2000000 $6000000
To finance the purchase, Ranch Manufacturing will sell 10-year bonds paying interest at a rate of 7% 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?