Rick Limited is trying to calculate its cost of capital for use in a capital budgeting decision. The CFO has given you the following information and has asked you to compute the weighted average cost of capital (WACC).

Debts (Bonds only) The company currently has outstanding a bond (Bond A) with a 12.2% coupon rate and another bond (Bond B) with a 9.5% coupon rate. The company has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 13.6%. The total book value of Bond A and B is $200,000,000, and the total market value is $170,000,000.

Common stock The company has 8,200,000 common stock outstanding, and each has a par value of $15. The current market value of the common stock is $58 per share and it has just paid dividend of $4.8 per share. The firms historical growth rate of earnings and dividends per share has been 9.5%, but security analysts on Wall Street expect this growth to slow to 7% in coming year and the future years.

Preferred stock The company has 630,000 preferred stock outstanding, and each has a par value of $50 with 13.5% dividend rate on par value. The preferred stock is currently trading at $54 per share on stock exchange.

Additional information

1. The company is subject to 25% corporate tax rate.

2. The company will maintain the current optimal capital structure, based on the respective source of capitals current market value.

Required:

1. Calculate the cost of debt, cost of common stock and cost of preferred stock. (10 marks)

2. Calculate the respective percentage of debt, common stock and preferred stock to Rick Limiteds current optimal capital structure. (8 marks)

3. Calculate Rick Limiteds WACC. (4 marks)

4. Comment if you agree or disagree to the following statements: (8 marks)

Statement 1: A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.

Statement 2: The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a company

Statement 3: Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than creditors, receive the benefits of steady cash flows.