Question

A firm maintains a debt-to-equity ratio of 0.35 and has a tax rate of 26%. The company does not issue preferred stock but has a pre-tax cost of debt of 6.25%. There are 20,000 shares of the company's stock outstanding with a beta of 0.9 and market price of $22.80. Yesterday, the company issued an annual dividend in the amount of $1.45 per share. Dividends are expected to grow at 2.34% indefinitely. What is the company's weighted average cost of capital? 6.98% 7.17% 7.37% 7.56% 7.75%

Answer 1

Debt to equity ratio = 0.35

D+E = 0.35 + 1 = 1.35

As debt weight = D/(D+E) = 0.35/1.35 = 0.26

Equity weight = E/(D+E) = 1/1.35 = 0.74

So Debt weight = 26% whereas Equity weight = 74%

After tax Cost of debt = Pre tax cost of debt * ( 1- tax rate) = 6.25% * (1 - 26%) = 4.625%

Cost of equity:

Using Gordon Model, Stock price = D0 (1+g)/(r - g)

Stock price = 22.80, g = 2.34%, D0 = 1.45

22.80 = 1.45 * (1+2.34%)/(r - 2.34%)

On solving this we get r or cost of equity as 8.85%

WACC or weighted average cost of capital = Weight of debt * After tax cost of debt + Weight of equity * Cost of equity = 26% * 4.625% + 74% * 8.85% = 7.75%