Computation of weighted average cost of capital

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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.

Reference no: EM139655

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