You are working as a consultant to the Lulu Athletic Clothing Company, and you have been asked to compute the appropriate discount rate to use in the evaluation of the purchase of a new warehouse facility. You have determined the market value of the firm's current capital structure (which the firm considers to be its target mix of financing sources) as follows:
Source of Capital _________________Market Value
Bonds ......................................... $300,000
Preferred stock .............................. $200,000
Common stock .............................. $500,000
To finance the purchase, Lulu will sell 20-year bonds with a $1,000 par value paying 6 percent per year (with interest paid semiannually) at the market price of $1,020. Preferred stock paying a $2.50 dividend can be sold for $35. Common stock for Lulu is currently selling for $50 per share. The firm paid a $4 dividend last year and expects dividends to continue growing at a rate of 4 percent per year for the indefinite future. The firm's marginal tax rate is 34 percent. What discount rate should you use to evaluate the warehouse project?