Question

You were hired as a consultant to Biggers Corp., and you were provided with the following data: Target capital structure: 20% debt and 80% common equity. The yield to maturity for the companyâ s debt is 6.0%. The companyâ s common stock is trading at a price of $50.00. The company is expected to pay a dividend of $3.50 next year (D1), and this dividend is expected to grow at a constant rate of 4.0%. The tax rate is 40%. Suppose the firm has no retained earnings to invest but must instead issue new stock (You cannot use rs from the DCF model any more). The costs for issuing new common stock are 12.0% of capital raised. What is the firmâ s WACC given this new information (round to 1 decimal place)?

Answer 1

Weight of Debt = 20%

Cost of Debt = 6%

Weight of Equity =80%

Cost of equity can be estimated using Gordon's constant growth model

P0 = D1/(r-g)

where P0 is the stock price today, D1 is the dividend next year

r is the cost of equity and g is the constant growth rate

So, r = D1/P0+g = 3.5/50+0.04 =0.11 or 11%

For new common stock with 12% cost (88% of amount will be realised) ,

The cost of equity = 11%/0.88 = 12.5%

So, WACC = weight of debt* cost of debt* (1-taxrate) + weight of equity*cost of equity

=0.2*0.06*(1-0.4)+0.8*0.125

=10.72% or 10.7%