Question 4

You are working in the Finance Department of Ranch Manufacturing, and your supervisor has asked you to compute the appropriate discount rate to use when evaluating the purchase of new packaging equipment for the plant. Under the assumption that the firms present capital structure reflects the appropriate mix of capital sources for the firm, you have determined the market value of the firms capital structure as follows:

Bonds $4,000,000

Preferred stocks $2,000,000

Common Stock $6,000,000

To finance the purchase, Ranch Manufacturing will sell 10-year bonds paying interest at a rate of 7 percent per year (with interest paid semi-annually) at the market price of $1,050. Preferred stock paying a $2.00 dividend can be sold for $25. Common stock for Ranch Manufacturing is currently selling for $55 per share, and the firm paid a $3 dividend last year. Dividends are expected to continue growing at a rate of 5 percent per year for the indefinite future. If the firms tax rate is 30 percent, what discount rate should you use to evaluate the equipment purchase? (6 marks)