Question

New and Improved (NAI) has a target capital structure of 50% equity and 50% debt to fund its $5 billion in capital. Furthermore, NAI has a WACC of 12.0 percent. Assume NAI’s before-tax cost of debt is 8% , its’ tax rate is 30 percent and its’ retained earnings are adequate to fund the common equity portion of the capital budget. If the expected dividend next year is $4 and the current stock price is $40, what is the company's expected growth rate?

Answer 1

WACC = (weight of debt * cost of debt) + (weight of common stock * cost of equity)

WACC = (weight of debt * before-tax cost of debt * (1 - tax rate)) + (weight of common stock * cost of common stock)

12% = (50% * 8% * (1 - 30%)) + (50% * cost of equity)

cost of equity = (12% - (50% * 8% * (1 - 30%)) / 50%

cost of equity = 18.40%

cost of equity = (next year dividend / current stock price) + growth rate

18.40% = ($4 / $40) + growth rate

growth rate =  18.40% - ($4 / $40)

growth rate =  8.40%