In October 2012, Builtwell Construction Company executives were working on their budget for 2013. Builtwell expects to have the following book value capital structure on December 31, 2012:
Debt ...................$ 12,000,000
Preferred stock (25,000 shares) ........$ 2,500,000
Common stock (1,000,000 shares) ......$ 5,000,000
Retained earnings ..............$ 10,000,000
Total capital .................$ 29,500,000
Earnings per share have grown steadily over the past seven years, from $1.65 in 2005 to $3.00 projected for 2012. The investment community expects growth to continue but at a slower rate; the average past growth rate of 9 percent has recently dropped to 5 percent, and it is expected to remain constant at this level. Based on a 5 percent growth rate, the stock now sells at a price/earnings (P/E) ratio of 6x (note, P = EPS x P/E). The last dividend, D0, was $1.88; it is expected to increase at the new 5 percent growth rate.
Builtwell's preferred stock, which was issued several years ago, has a book value of $100 per share, and it pays a dividend of $9. The yield currently on preferred stock of this degree of risk is 11.25 percent. The debt consists of $12,000,000 of $1,000 par, 20-year bonds with a 7 percent coupon, payable semiannually. These bonds were issued 7 years ago, and hence have 13 years remaining to maturity. The yield-to-maturity for these bonds is currently 9.227 percent. The corporate tax rate, including state income taxes, is 40 percent.
a. What is the weighted average cost of capital based on book value capital structures?
b. What is the weighted average cost of capital based on market capital structures?