Question

Hook Industries's capital structure consists solely of debt and common equity. It can issue debt at r_d = 8%, and its common stock currently pays a $3.50 dividend per share (D₀ = $3.50). The stock's price is currently $22.25, its dividend is expected to grow at a constant rate of 4% per year, its tax rate is 25%, and its WACC is 12.20%. What percentage of the company's capital structure consists of debt? Do not round intermediate calculations. Round your answer to two decimal places.

%

Answer 1

After-tax Cost of Debt

After-tax Cost of Debt = Pre-tax Cost of Debt x (1 – Tax rate)

= 8.00% x (1 – 0.25)

= 8.00% x 0.75

= 6.00%

Cost of Equity

Cost of Equity = (D1 / P0) + g

= [D0(1 + g) / P0] + g

= [$3.50(1 + 0.04) / $22.25] + 0.04

= [$3.64 / $22.25] + 0.04

= 0.1636 + 0.04

= 0.2036 or

= 20.36%

Let’s take “X” as the Weight of Debt and (1 – X) as the Weight of Equity

Weighted average cost of capital (WACC) = [After-tax Cost of Debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

12.20 = [6.00 x X] + [20.36 x (1 – X)]

12.20 = 6.00X + 20.36 – 20.36X

20.36 – 12.20 = 20.36X – 6.00X

8.16 = 14.36X

X = 8.16 / 14.36

X = 0.5682 or

X = 56.82%

Therefore, the percentage of the debt in the company's capital structure will be 56.82%