Question

A software firm is expected to pay a $3.50 dividend at year end (D1 = $3.50), the dividend is expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 20%. The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?

a. 8.82%

b. 9.06%

c.9.66%

d.10.82%

Answer 1

The cost of equity is calculated using the dividend discount model. It is calculated using the below formula:

Ke= D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= $3.50 / $62.50 + 0.0650

= 0.0560 + 0.0650

= 0.1210*100

= 12.10%

WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.40*7.50%*(1 - 0.20) + 0.60*12.10%

= 0.40*6% + 0.60*12.10%

= 2.40% + 7.26%

= 9.66%.

Hence, the answer is option c.