Cost of Capital. The Conner Company has the following capital structure:
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Mortgage bonds, 6%
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$ 20,000,000
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Common stock (1 million shares)
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25,000,000
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Retained earnings
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55,000,000
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$100,000,000
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Mortgage bonds of similar quality could be sold at a net of 95 to yield 6½ percent. Their common stock has been selling for $100 per share. The company has paid 50 percent of earnings in dividends for several years and intends to continue the policy. The current dividend is $4 per share. Earnings are growing at 5 percent per year. If the company sold a new equity issue, it would expect to net $94 per share after all costs. Their marginal tax rate is 50 percent. Conner wants to determine a cost of capital to use in capital budgeting. Additional projects would be financed to maintain the same relationship between debt and equity. Additional debt would consist of mortgage bonds, and additional equity would consist of retained earnings. (a) Calculate the firm's weighted average cost of capital, and (b) explain why you used the particular weighting system.