1. Given the following information, calculate the weighted average cost of capit

Question

1. Given the following information, calculate the weighted average cost of capital for Digital Processing Inc. Line up the calculations in the order shown in Table 11-1. Percent of capital structure: Preferred stock................ 20% Common equity............... 40 Debt................................. 40 Additional information: Corporate tax rate............................. 34% Dividend, preferred........................... $8.50 Dividend, expected common............. $2.50 Dividend, preferred........................... $105.00 Growth rate....................................... 7% Bond yield.......................................... 9.5 Flotation cost, preferred.................... $3.60 Price, common................................... $75.00

Explanation / Answer

To calculate the average cost of capital, we need to determine the cost of debt, cost of equity and cost of preferred stock with the use of information available in the question. The formula for calculating weighted average cost of capital is given below:

Weighted Average Cost og Capital = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

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Step 1: Calculate After-Tax Cost of Debt

The after-tax cost of debt can be calculated with the use of following formula:

After-Tax Cost of Debt = Yield*(1-Tax Rate) = 9.5%*(1-34%) = 6.27%

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Step 2: Calculate Cost of Preferred Stock

The cost of preferred stock can be calculated with the use of following formula:

Cost of Preferred Stock = Annual Dividend/(Current Price - Flotation Cost)*100 = 8.50/(105 - 3.60)*100 = 8.38%

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Step 3: Calculate Cost of Equity

The cost of equity can be calculated with the use of following formula:

Cost of Equity = Expected Dividend/Current Price + Growth Rate = 2.50/75 + 7% = 10.33%

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Step 4: Calculate Average Cost of Capital

Using the values calculated above and weights provided in the question, we get,

Weighted Average Cost of Capital = 6.27%*40% + 8.38%*20% + 10.33%*40% = 8.32% (answer)

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