Question: Rolodex, Inc. would like to calculate its average cost of capital for the coming year. The capital budgeting plans call for funds totaling USD 200 million for the coming year. These funds will be raised from preferred stock, long-term debt & common equity in the same proportions as their book values in the firm's balance sheet shown below:
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Rolodex, Inc. Balance Sheet (in millions of dollars)
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Current assets
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$110
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Accounts payable
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$30
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Fixed assets
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260
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Other current liabilities
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20
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Total assets
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$370
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Long-term debt
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128
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Preferred stock
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32
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Common stock (20 million shares at par)
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20
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Contributed capital in excess of par
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30
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Retained earnings
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110
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Total liabilities and equity
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$370
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Conversation between the firm's financial officers and the firm's investment and commercial bankers have yielded the following information:
- Rolodex's maximum borrowing is $80 million from its bank at a pretax cost of 13 percent.
- Preferred stock can be issued at a pretax cost of 16.5 percent
- Rolodex expects to generate $140 million in net income. Any earnings remaining after meeting the equity portion of the $200 million capital expenditure budget will be paid out as dividends.
- The risk-free rate of return is 5.5 percent. The market risk premium is assumed to equal 10% and Rolodex's beta is estimated to be 1.2.
- Rolodex's marginal tax rate if 40 percent.
Calculate Rolodex's weighted average cost of capital for the coming year.