Question

A company finances its operations with 50 percent debt and 50 percent equity. Its net income is I = $30 million and it has a dividend payout ratio of x = 20%. Its capital budget is B = $40 million this year. The interest rate on company's debt is rd = 10% and the company's tax rate is T = 40%. The company's common stock trades at Po = $66 per share, and its current dividend of Do = $4 per share is expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if issued, is F = 5% of the dollar amount issued. a) Will the company have to issue external equity (external equity implies issuing new stock while internal equity implies using retained earnings)? b) What is the company's WACC?

Answer 1

a. Cost of External Equity =Dividend next year/(Price*(1-Flotation Cost)) +growth =4*(1+10%)/(66*(1-5%))+10% =17.0175%

b. WACC =Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt*(1-Tax Rate)
=50%*17.0175%+50%*10%*(1-40%) =11.51%