Question

Salma Limited finances its operations 40% debt and 60% equity. The company cost of debt is 10%.

Stocks of the company currently trade at $55 and dividends of $5 per share was paid. The share is price

is expected to grow at a constant rate of 10% a year.

N.B.

Flotation cost for equity is 5% of the share price;

Tax rate is 30%.

Compute the following:

a) Cost of ordinary share capital;           

b) After-tax cost of debt; and                 

c) Weighted average cost of capital (WACC).     

Answer 1

a) Proceeds from capital raise per share = share price*(1-flotation cost)

=55*(1-0.05)=52.25

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

52.25 = 5 * (1+0.1) / (Cost of equity - 0.1)

Cost of equity% = 20.53

b)

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 10*(1-0.3)

= 7

c)

Weight of equity = 1-D/A

Weight of equity = 1-0.4

W(E)=0.6

Weight of debt = D/A

Weight of debt = 0.4

W(D)=0.4

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=7*0.4+20.53*0.6

WACC% = 15.12