Question

WACC and Percentage of Debt Financing

Hook Industries' capital structure consists solely of debt and common equity. It can issue debt at r_d = 11%, and its common stock currently pays a $2.25 dividend per share (D₀ = $2.25). The stock's price is currently $22.50, its dividend is expected to grow at a constant rate of 8% per year, its tax rate is 40%, and its WACC is 14.95%. What percentage of the company's capital structure consists of debt? Round your answer to two decimal places.

Answer 1

According to Gordon Growth Rate, Value of stock = D₁/ (k - g)

Given, Value of the stock = $22.50

Growth rate of dividend = g = 8%

D1 = D0(1+g)

=> 22.50 = 2.25*1.08/(Re - 0.08)

=> Re = 0.188 or 18.80%

WACC = w_e*Re + w_d*Rd*(1-Tc)

where,

w_e = weight of equity
w_d = weight of debt
w_e + w_d = 1
Re = cost of equity
Rd = cost of debt = 11%
Tc = corporate tax rate = 40%
WACC = 14.95%

=> 14.95 = w_e*0.188 + w_d*0.11*(1-0.40)

w_e = 1 - w_d

=> 0.1495 = (1 - w_d)*0.188 + w_d*0.11*(1-0.40)

=> 0.1495 = 0.188 - 0.188w_d + 0.066w_d

=> 0.122w_d = 0.0385

=> w_d = 0.3156

Hence, 31.56% is allocated to debt