Question

1. Watta Corp has a beta of .80. The market risk premium is 6%, and the risk-free rate is 6%. Watta’s last dividend was $20 per share, and the dividend is expected to grow at 8% indefinitely. The stock currently sells for $45 per share. What’s Watta’s cost of equity capital?
2. From worksheet 1 chapter 14, suppose Watta Corp from #5 has a target debt-equity ratio of 50%. Its cost of debt is 9% before taxes. If the tax rate is 35%, what is the WACC? This is all the information given.

Answer 1

As per CAPM =

= 6% + 0.80 (6%)

= 10.8%

As per Dividend Growth Model

Value of Stock =

45 =

Rate of Return * 45 - 0.08 * 45 = 21.6

Rate of Return * 45 - 3.6 = 21.6

Rate of Return = (21.6 + 3.6) / 45

Rate of Return = 56% (this Rate of Retrun is too high)

Now,

Debt is 0.5

Equity is 1

Total is 1.5

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 10.8% * 1 / 1.5 + 9(1-0.35) * 0.5 / 1.5

= 7.2% + 1.95%

= 9.15%