Question

A. Summerdahl Resort's common stock is currently trading at $39 a share. The stock is expected to pay a dividend of $1.00 a share at the end of the year (D1 = $1.00), and the dividend is expected to grow at a constant rate of 7% a year. What is the cost of common equity? Round your answer to two decimal places.

B. Shi Import-Export's balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi's tax rate is 25%, r_d = 7%, r_ps = 6.1%, and r_s = 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is its WACC? Round your answer to two decimal places.

Answer 1

A]

cost of common equity = (D1 / P0) + g

where D1 = expected dividend next year

P0 = current stock price

g = growth rate

cost of common equity = ($1 / $39) + 0.07

cost of common equity = 0.0956, or 9.56%

B]

WACC should be based on target capital structure weights, and not the book value weights. This is because the firm is expected to have the target capital structure in the near future.

WACC = (weight of debt * after-tax cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

WACC = (30% * (7% * (1 - 25%))) + (5% * 6.1%) + (65% * 12%)

WACC = 0.0968, or 9.68%