You have been asked to estimate the weighted average cost of capital (WACC) for Knollwood Inc., a large camping supplies company. To assist with your calculations, you have been provided with the following information.

1. Bonds -- Knollwood has 25,000 of $100 face value bonds outstanding. The bonds carry a 6% coupon rate with interest paid semi-annually. At their current market price of $92.89 per bond, they are priced to provide a yield to maturity of 7%. The bonds have 10 years remaining until maturity.

2. Preferred shares -- Knollwood has 2 million preferred shares outstanding. The shares carry a stated dividend of $1.60 per share and have a current market price of $22 per share.

3. Common shares -- Knollwood has 3 million common shares outstanding. The current market price of the shares is $53.20 each. The shares paid a dividend of $2.70 per share last year and investment analysts believe the dividends should grow at an average annual rate of 5% for the foreseeable future.

REQUIRED:

a) Calculate Knollwoods weighted average cost of capital (WACC), assuming that the company intends to issue new common shares. The companys tax rate is 40%.(10 marks)

b) If a firm changes its mix of debt and equity financing, its weighted average cost of capital will change for 2 main reasons. Identify these 2 reasons, and briefly explain why the firms WACC will change. (4 marks)