Question

Management of the IsItOverYet? Company needs to determine its cost of capital in order to evaluate some large capital purchases. The company's bonds have a yield to maturity of 6%, last dividend paid on common stock was $2.16 per share, current stock price is $47/share, and constant growth of 4% is expected on dividends and earnings. The company's capital structure is 40% debt, 60% equity. There is no preferred stock and the marginal tax rate is 21%.   SHOW ALL WORK FOR FULL CREDIT.
a) 2 pts. What is the after-tax cost of debt?
b) 4 pts. What is the cost of equity?
c) 6 pts. What is the company's cost of capital (WACC)?

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Answer 1

a.After tax cost of debt= Before tax cost of debt*(1 - tax rate)

= 6%*(1 - 0.21)

= 4.74%.

b.The cost of equity is calculated using the dividend discount model. It is calculated using the below formula:

Ke=D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= Cost of equity

Ke= $2.16*(1 + 0.04)/ $47 + 0.04

= $2.2464/ $47 + 0.04

= 0.0478 + 0.04

= 0.0878*100

= 8.78%.

c. WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.40*4.74% + 0.60*8.78%

= 1.8960% + 5.2680%

= 7.1640% 7.16%.

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