Marakesh Tap Company is a manufacturer of diamond drilling, cutting, and grinding tools. $1,000,000 of its 8% bond issue will mature next month. To retire this debt, $1,000,000 in cash must be raised. One proposal under consideration is the sale and leaseback of the company's general office building.
The building would be sold to FHR Inc. for $1,000,000 and leased back on a 25-year lease, with annual payments of $110,168, permitting the lessor to recover its investment and earn 10% on the investment. Marakesh Tap will pay all maintenance costs, property taxes, and insurance and will reacquire the building at the end of the lease period for a nominal payment.
The current capital structure is:
Pretax Pretax Cost ofCapital ComponentAmount Component
Bonds (including amount to be retired next month)$5,000,000 8.0%
Preferred stock (market value)1,000,000 9.0%
Common stock and retained earnings (market value)4,000,000 12.5%
Marakesh Tap's income tax rate is 40%.
Required: Compute the weighted-average cost of capital before and after the bond retirement and the sale-leaseback transaction.