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 25%, 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 $14.00 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?

9.51%

7.98%

10.12%

8.75%

Answer #1

Expected Dividend (D1) = $0.65

Floatation Cost = 10%

Growth Rate = 6%

Stock Price (P)= $14

Now, Cost of Equity = [D1/P*(1-Floatation Cost)]+ Growth Rate

Cost of Equity = [0.65/14(0.90)] + 6%

Cost of Equity = 11.159%

Given the Pre Tax Cost of Debt = 7.75 %

Tax Rate = 25%

Post Tax Cost of Debt = Pre Tax Cost x (1-Tax Rate)

Post Tax Cost of Debt = 7.75%(1-0.25) = 5.8125%

Given the Target Capital Structure with weightage of Debt and equity of 45% and 55% respectively

Now WACC = Weight of Debt x Post Tax Cost of Debt + Weight of Equity x Cost of Equity

WACC = 0.45*5.8125% + 0.55*11.159%

**WACC = 8.75%**

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