Question

Midnight dreamers use only debt and equity. it can borrow unlimited amount at an interest rate of 10% as long as it finances at its target capital structure which calls for 45% debt and 55% common equity. The last dividend was 66 its expected constant growth rate is 4% and its stock sells at a price of 20. Mid night dreamers tax rate is 40% a) what is the companies cost of common equity b) what is their WACC

Answer 1

(a) Companies cost of common equity (Ke) = 7.43%

Last Year Divided (D0) = $0.66

Next Year Dividend (D1) = D0 [ 1+g] = $0.66 [ 1.04] = $0.6864

Current Market Price (P0) = $20

P0 = D1 / [ Ke – g ]

$20 = $0.6864 / [ Ke -0.04 ]

[ Ke – 0.04 ] = 0.0343

Ke = 0.0343 + 0.04

= 0.0743 or

= 7.43%

Companies cost of common equity [Ke] = 7.43%

(b)Weighted Average Cost of Capital [WACC] = 6.79%

Weighted Average Cost of Capital [WACC]

= [ Cost of Common Equity x Weight of Equity ] + [ After Tax Cost of Debt x Weight of Debt ]

= [ 7.43% x 0.55 ] + [ (10% x 0.60) x 0.45 ]

= 4.09% + 2.70%

= 6.79%