Reference no: EM1315339

Compute the weighted cost of capital that is appropriate to use in evaluating this expansion program

1. The comfort corporation manufactures sofas and tables for the recreational vehicle market. The firms capital structure consists of 60% common equity, 10% preferred stock, and 30% long term debt. This capital structure is believed to be optimal. Comfort will require $120 million to finance expansion plans for the coming year. The firm expects to generate enough internal equity to meet the equity portion of its expansion needs. The cost of retained earnings is 18%. The firm can raise preferred stock at a cost of 15%. First-mortgage bonds can be sold at a pre-tax cost of 14%. The firm\'s marginal tax rate is 40%.

Compute the cost of capital for the funds needed to meet the expansion goal

2. 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 as shown below:

Rolodex Inc Balance Sheet (in millions of dollars)

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 is 40%

Compute Rolodex's weighted average cost of capital for the coming year.