Computation of weighted average cost of capital.
Rolodex, Inc. would like to estimate its average cost of capital for the coming year. The capital budgeting plans call for funds totaling $200 million for the coming year. These funds will be raised from long-term debt, preferred stock, and common equity in the same proportions as their book values in the firm's balance sheet shown below:
Rolodex, Inc. Balance Sheet (in millions of dollars)
Current assets $110 Accounts payable $30
Fixed assets 260 Other current liabilities 20
Total assets $370 Long-term debt 128
Preferred stock 32
Common stock (20 million shares at par) 20
Contributed capital in excess of par 30
Retained earnings 110
Total liabilities and equity $370
Discussions between the firm's financial officers and the firm's investment and commercial bankers have yielded the following information:
• Rolodex's maximum borrowing is $80 million from its bank at a pretax cost of 13%.
• Preferred stock can be issued at a pretax cost of 16.5%
• Rolodex expects to generate $140 million in net income. Any earnings remaining after meeting the equity portion of the $200 million capital expenditure budget will be paid out as dividends.
• The risk-free rate of return is 5.5%. The market risk premium is assumed to equal 10% and Rolodex's beta is estimated to be 1.2.
• Rolodex's marginal tax rate if 40%.
Compute Rolodex's weighted average cost of capital for the coming year.