Question

The Woodsburg Co. maintains a debt-equity ratio of .60 and has a tax rate of 35 percent. The firm does not issue preferred stock. The firm's pre-tax cost of debt is 8.75 percent. Woodsburg Co. has 20,000 shares of stock outstanding with a beta of .9 and a market price of $30. The current market risk premium is 7 percent and the current risk-free rate is 3 percent. Last month, Woodsburg Co. issued an annual dividend in the amount of $1.25 per share. Dividends are expected to grow at 2 percent indefinitely. Using an average expected cost of equity, what is Woodsburg's weighted average cost of capital?

Answer 1

After-tax cost of debt (rd) = pre-tax cost of debt*(1-tax rate) = 8.75%*(1-35%) = 5.6875%

Cost of equity (using CAPM) = risk-free rate + beta*market risk premium

= 3% + 0.9*7% = 9.30%

Cost of equity (using dividend discount model) = (expected dividend/price) + growth rate

= (1.25*(1+2%)/30) + 2% = 6.25%

Average cost of equity (re) = (9.30% + 6.25%)/2 = 4.65%

D/E ratio = 0.60 so E/(D+E) = 1/(1+0.6) = 0.625

D/(D+E) = 1-0.625 = 0.375

WACC = (rd*D/(D+E)) + (re*E/(D+E)) = (5.6875%*0.375) + (4.65%*0.625) = 5.039%