Question

Sally Gross, an investment analyst, has collected the following information regarding Lehman & Tiffany Co.:

--The yield to maturity (YTM) on the company's bonds is 10 percent.

--The company's current dividend is $0.80 a share.

--The company's stock price is $22.

--The company expects that its dividend will grow at a constant rate of 8 percent a year.

--The company's capital structure is 65 percent equity and 35 percent debt. The company's tax rate is 40%.

--The company anticipates that total flotation costs will equal 11 percent of the amount issued.

Assume the company accounts for flotation costs. Calculate the company's WACC.

Answer 1

Given for Tiffany Co.

YTM of the company's bond = 10%

So, Cost of Debt Kd = 10%

D0 = $0.80

P0 = $22

growth rate = 8%

using constant growth model to compute price of the stock with cost of equity = Ke

P0 = D0*(1+g)/(Ke-g) => 22 = 0.8*1.08/(Ke - 0.08)

So, Cost of equity Ke = 11.93%

Weight of debt wd = 35%

weight of equity we = 65%

tax rate = 40%

WACC = Ke*we + Kd*wd*(1-t) = 0.65*11.93 + 0.35*10*(1-0.4) = 9.85%

flotation cost = 11%

So, revised WACC = WACC/(1-flotation cost) = 9.85/(1-0.11) = 11.07%