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The following data refers to the next three questions: You were hired as a consultant to...

The following data refers to the next three questions: You were hired as a consultant to Biggers Corp., and you were provided with the following data: Target capital structure: 30% debt and 70% common equity. The yield to maturity for the company’s debt is 7.0%. The company’s common stock is trading at a price of $50.00. The company is expected to pay a dividend of $4.00 next year (D1), and this dividend is expected to grow at a constant rate of 4.0%. The tax rate is 25%.

What is the company’s cost of equity assuming the company has sufficient retained earnings and need not issue new shares (round to nearest percentage)?

a.    7.2%

b.   9.0%

c.    10.0%

d.   11.0%

e.    12.0%

Assuming the firm will not be issuing any new stock and instead will use retained earnings. What is the firm’s WACC (round to 1 decimal place)?

a.    7.7%

b.   7.8%

c.    8.1%

d.   9.5%

e.    10.0%

Suppose the firm has no retained earnings to invest but must instead issue new stock. The flotation costs for issuing new common stock are 15.0% of capital raised. What is the firm’s WACC given this new information (round to 1 decimal place)?

a.    8.1%

b.   8.4%

c.    8.6%

d.   10.3%

e.    11.0%

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Answer #1

Answer a.

Cost of Equity = Expected Dividend / Current Price + Growth Rate
Cost of Equity = $4.00 / $50.00 + 0.04
Cost of Equity = 0.08 + 0.04
Cost of Equity = 0.12 or 12.0%

Answer b.

WACC = Weight of Debt * Cost of Debt * (1 - tax) + Weight of Equity * Cost of Equity
WACC = 30% * 7.0% * (1 - 0.25) + 70% * 12.0%
WACC = 1.6% + 8.4%
WACC = 10.0%

Answer c.

Net Price = Current Price * (1 - Flotation Cost)
Net Price = $50.00 * (1 - 0.15)
Net Price = $42.50

Cost of Equity = Expected Dividend / Net Price + Growth Rate
Cost of Equity = $4.00 / $42.50 + 0.04
Cost of Equity = 0.094 + 0.04
Cost of Equity = 0.134 or 13.4%

WACC = Weight of Debt * Cost of Debt * (1 - tax) + Weight of Equity * Cost of Equity
WACC = 30% * 7.0% * (1 - 0.25) + 70% * 13.4%
WACC = 1.6% + 9.4%
WACC = 11.0%

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