Question

The Cullumber Products Co. currently has debt with a market value of $300 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $871.72 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $20. The preferred shares pay an annual dividend of $1.20. Cullumber also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 7 percent per year forever. If Cullumber is subject to a 40 percent marginal tax rate and firm's. Calculate the appropriate cost of capital for a new project that is financed with the same proportion of debt, preferred shares, and common shares as the firm's current capital structure. Also assume that the project has the same degree of systematic risk as the average project that the firm is currently undertaking (the project is also in the same general industry as the firm's current line of business). Appropriate cost of capital %

Answer 1

To calculate the appropriate cost of capital for Cullumber Products Co., we need to consider the after-tax cost of debt, the cost of preferred stock, and the cost of equity. Each component must be weighted according to its proportion in the company's current capital structure to determine the weighted average cost of capital (WACC).

Step-by-step explanation:

The student is asking how to calculate the appropriate cost of capital for a new project that Cullumber Products Co. is considering.

Given the company's existing capital structure, which includes debt, preferred stock, and common stock, the cost of capital must reflect the weighted average cost of debt (after tax), cost of preferred stock, and cost of equity.

To compute these, we will use the market value of debt, price, and dividends of preferred shares, and the dividend growth model for equity.

Tax considerations for debt must also be factored into the calculation due to the interest expense being tax-deductible.

Finally, the student must weigh these costs according to the proportion of each type of capital in the firm's current structure to find the weighted average cost of capital (WACC).

Answer 2

To calculate the appropriate cost of capital, we consider the company's mixture of debt, preferred stock, and common equity, along with their respective market values and costs. We then use these to compute the weighted average cost of capital (WACC), accounting for the tax benefits from debt and the perpetual growth of dividends for common stock.

Step-by-step explanation:

Cost of Capital Calculation

To calculate the appropriate cost of capital for the new project that Cullumber Products Co. is undertaking, we must take into account the company's current capital structure and the costs associated with each component. The current capital structure includes debt, preferred shares, and common stock. We need to find the market value proportions of each and calculate the after-tax cost of debt, cost of preferred equity, and cost of common equity to then calculate the weighted average cost of capital (WACC).

The after-tax cost of debt is calculated based on the current yield of the bonds, wherein the tax shield provided by the interest expense is taken into account. The cost of preferred equity is determined by dividing the annual dividend by the market price of the preferred stock. Lastly, the cost of common equity can be estimated using the Gordon Growth Model as this firm's dividends are expected to grow perpetually at a constant rate.

With the calculated costs, we then multiply each cost by its respective proportion in the total market value of the firm to find the weighted costs. Summing these up gives us the WACC, which is the appropriate cost of capital for projects with the same risk profile as the firm's current projects.