Question

1. Charmant Kems, the Canadian, has an optimal capital structure consists of 60% debt and 40% equity. Charnant will not have enough retained earnings to fund the equity portion of its capital budget, and the cost of capital is adjusted to account for flotation costs. Given the following information, calculate the firm’s WACC.

r_d = 8%.

Net income = $40,000.

Payout ratio = 80%.

Tax rate = 45%.

P₀ = $25.

Growth = 0%.

Shares outstanding = 10,000.

Flotation cost on additional equity = 10%.

Answer 1

The WACC is computed as shown below:

= cost of debt x (1 - tax rate) x weight of debt + cost of equity x weight of equity

cost of equity is computed as follows:

= Dividend / P0 + growth rate

Dividend is computed as follows:

= (Net income x Payout ratio) / Number of shares outstanding

= ($ 40,000 x 80%) / 10,000

= $ 3.20

So, the cost of equity is computed as follows:

= $ 3.20 / $ 25 + 0

= 12.8% or 0.128

So, the WACC will be computed as follows:

= 0.08 x (1 - 0.45) x 0.60 + 0.128 x 0.40

= 0.0264 + 0.0512

= 7.76%

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