Sierra Vista Industries (SVI) wishes to estimate its cost of capital for use in analyzing projects that are similar to those that already exist. The firm's current capital structure, in terms of market value, includes 40 percent debt, 10 percent preferred stock, and 50 percent common stock.
The firm's debt has an average yield-to-maturity of 8.3 percent. Its preferred stock has a $70 par value, an 8 percent dividend, and is currently selling for $76 per share. SVI's beta is 1.05, the risk-free rate is 4 percent, and the return on the S&P 500 (the market proxy) is 11.4 percent. SVI is in the 40 percent marginal tax bracket.
a. What are SVI's pretax costs of debt, preferred stock, and common stock?
b. Calculate SVI's weighted average cost of capital (WACC) on both a pretax and an after-tax basis. Which WACC should SVI use when making investment decisions?
c. SVI is contemplating a major investment that is expected to increase both its operating and financial leverage. Its new capital structure will contain 50 percent debt, 10 percent preferred stock, and 40 percent common stock.
As a result of the proposed investment, the firm's average yield-to-maturity on debt is expected to increase to 9 percent, the market value of preferred stock is expected to fall to its $70 par value, and its beta is expected to rise to 1.15. What effect will this investment have on SVI's WACC? Explain your finding.