Question

The market value of Exxon Corporation's common stock is $40 million and the market value of its risk-free debt is $60 million. The firm's stock is currently trading at $32 and has just paid a dividend of $4.0 per share which is expected to growth at 3% forever. If the Treasury bill rate is 6 percent, what is the firm's cost of capital? (Assume no taxes.)

a. 9.95

b 15.50

c 7.46.

d 13

Answer 1

Given about Exxon Corporation,

market value of common stock = $40 million

market value of its risk-free debt = $60 million

=> Weight of equity We = stock/(debt + stock) = 40/(60+ 40) = 40%

Weight of debt Wd = debt/(debt + stock) = 60/(60 + 40) = 60%

The firm's stock is currently trading at $32 and has just paid a dividend of $4.0 per share which is expected to growth at 3% forever.

So its cost of equity using constant dividend growth model is

Ke = D0*(1+g)/P0 + g = 4*1.03/32 + 0.03 = 15.875%

Treasury bill rate is 6 percent

Since firm debt are risk free, cost of debt Kd = 6%

So, WACC of the firm = Wd*Kd + We*Ke = 0.6*6 + 0.4*15.875 = 9.95%

Option a is correct.