Question

Management of the IsItOverYet? Company needs to determine its cost of capital in order to evaluate...

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)?

SHOW ALL WORK on the TI BAII Plus Calculator!!!!!

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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%.

In case of any query, kindly comment on the solution.

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