Question

Your firm is going to pay dividend $1 per share in the next year.

The current stock price is $10 per share

Firm beta is 10% higher than market average

Constant growth rate is 5%

Market risk premium is 10% and risk free rate is 2%

Market value of common stock is $100 million and market value of debt is $200 million

No preferred stock

Cost of borrowing/issuing bond is 5%

Corporate tax rate 40%

1. What is the cost of equity using dividend growth model?
2. What is the cost of equity using CAPM model
3. What is the weights for common stock and debt?
4. What is the WACC for your firm using cost of equity from CAPM?

Answer 1

a

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

10 = 1/ (Cost of equity - 0.05)

Cost of equity% = 15

b

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 2 + 1.1 * (10)

Cost of equity% = 13

c

Total Asset value = Value of Debt + Value of Equity

=200+100

=300

Weight of Debt = Value of Debt/Total Asset Value

= 200/300

=0.6667

Weight of Equity = Value of Equity/Total Asset Value

= 100/300

=0.3333

d

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

After tax cost of debt = 5*(1-0.4)

= 3

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

WACC=3*0.6667+13*0.3333

WACC% = 6.33