Deere Industries is considering three separate expansion projects that have been proposed by the companys manufacturing group. Before proceeding with any project, the company must estimate its cost of capital. You are a finance associate and the financial vice president, Katherine Barnes, has provided you with the following data, which she believes may be relevant to your task.

The firms tax rate is 40%.

The current price of Deeres 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is $1,153.72. Deere does not use short-term, interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firms 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10.

Deeres common stock is currently selling for $50.00 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Deeres beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%.

Deeres target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Barnes has asked you to answer the following questions:

1. What sources of capital should be included when you estimate Deeres WACC?

2. Should the component costs be figured on a before-tax or an after-tax basis?

3. Should the costs be historical (embedded) costs or new (marginal) costs?

4. What is the market interest rate on Deeres debt and its component cost of debt?

5. What is the firms cost of preferred stock? Deeres preferred stock is riskier to investors than its debt, yet the preferreds yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

6. Why is there a cost associated with retained earnings?

7. What is Deeres estimated cost of common equity using the CAPM approach?

8. What is the estimated cost of common equity using the DCF approach?

9. What is the bond-yield-plus-risk-premium estimate for Deeres cost of common equity?

10. What is your final estimate for Deeres cost of common equity? Explain in words why new common stock has a higher cost than retained earnings.