problem: The Ewing Distribution Company is planning a $100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed, in part, with debt issued with a coupon interest rate of 6.8 percent. The bonds have a ten year maturity and a USD 1,000 face value, and they will be sold to net Ewing USD 990 per bond. Ewing’s marginal tax rate is 40 percent.
Preferred stock will cost Ewing 7.5 percent after taxes. Ewing’s common stock pays a dividend of USD 2 per share. The current market price per share is USD 35. Ewing’s dividends are expected to increase at an annual rate of 5 percent for the foreseeable future. Ewing expects to generate sufficient retained earnings to meet the common equity portion of the funding needed for the expansion.
Ewing’s target capital structure is as follows:
Debt = 20 percent
Preferred stock = 5 percent
Common equity = 75 percent
Determine the weighted cost of capital that is appropriate to use in evaluating this expansion program.