Question

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Question: What is the firm's WACC, under the assumption that there will be no need to raise new equity? How much investment can be undertaken within the bounds of this assumption?

Earnings per share for Goh, Choe and Burgan (a major biotechnology manufacturing company) have grown at a rate averaging 6% over the last decade, reaching $2.00 last year, but with a standard deviation of earnings around the trend value of $0.84. The firm has 220,000 ordinary shares which are now selling for $10.76 per share, and the company has a constant dividend ratio policy (paying 30% of earnings) in most years, using the balance to fund the growth investments. The current interest rate on new debt is 9 percent. The tax rate is 40c in the dollar. The firm has an existing capital structure of 30% debt and 70% equity.

Answer 1

WACC ( Wieghted cost of capital) is nothing but the rate the company has to pay to its investors. It can be connsider as hurder rate for considering acceptance of a project.It is calculated by multiplying weights of sources of capital to its cost.

Now g = 6%,EPS of year 0 = 2, Proce if share = 10.76

cost of equity = D1/Po+g

=(2*1.06)*30%/10.76 + 0.06

=2.12*30%/10.76 + 0.06

=0.636/10.76 + 0.06

=0.059108+0.06

=11.9108%

cost of debt = 9%(1-tax rate)

=9%(0.6)

=5.4%

WACC = Weight of equity*Ke + Weight of debt*Kd

=70%*11.9108% + 30%*5.4%

=8.33756% + 1.62%

=9.95756%