The management of Clay Industries have adhered to the following capital structure: 50% debt, 45% common equity, and 5% perpetual preferred equity. The following information applies to the firm:

Before-tax cost of debt = 9.5%
Combined state/federal tax rate = 35%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.24
Expected annual preferred dividend = $1.55
Preferred stock net offering price = $24.50
Annual common dividend (expected) = $0.80
Common stock price = $30.90
Expected growth rate = 9.75%
Subjective risk premium = 3.3%

Given this information, and using the discounted cash flow (DCF) approach, what is the weighted average cost of capital for clay industries?

Explanation: The calculation of the weighted average cost of capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1- combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the capital asset pricing model (CAPM), the dividend-yield-plus-growth-rate (or discounted cash flow) approach, and the Bond-Yield-Plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the discounted cash flow, or dividend-yield-plus-growth-rate approach.

To calculate the cost of equity using this approach, take the expected annual dividend on common equity ($0.80) divided by the market price of common stock ($30.90), and add the expected growth rate (9.75%) to this figure. Using this method, the cost of common equity is found to be 12.34%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (9.5%) by (1 -tax rate). Using this method, the after-tax cost of debt is found as 6.175%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.957%.