Question

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company’s outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $16.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget? (Hint: required return on stock needs to be adjusted by flotation cost re = D1/(P0 × (1 - F)) + g) Group of answer choices 8.58% 7.80% 9.61% 9.45% 7.88%

Answer 1

Answer is 7.88%

Debt:

Pre-tax Cost of Debt = 7.75%

After-tax Cost of Debt = Pre-tax Cost of Debt * (1 - Tax Rate)
After-tax Cost of Debt = 7.75% * (1 - 0.40)
After-tax Cost of Debt = 4.65%

Equity:

Expected Dividend, D1 = $0.65
Growth Rate, g = 6.00%
Current Price, P0 = $16.00
Flotation Cost = 10%

Cost of Equity = D1 / [P0 * (1 - F)] + g
Cost of Equity = $0.65 / [$16.00 * (1 - 0.10)] + 0.06
Cost of Equity = $0.65 / $14.40 + 0.06
Cost of Equity = 0.105139 or 10.5139%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
WACC = 0.45 * 4.65% + 0.55 * 10.5139%
WACC = 7.88%