Question

Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost of capital can be summarized as follows: The company's bonds have a nominal yield to maturity of 7%. The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share. The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7% a year. The company has no retained earnings. The company's tax rate is 40%. What is the company's weighted average cost of capital (WACC)?

Answer 1

Answer:

WACC = 0.1018 or 10.18%

Explanation:

The WACC or Weighted average cost of capital is the cost of a firm's capital structure that can be made of one or all of the following components namely debt, preferred stock and common equity.

The formula to calculate is as follows,

WACC = wD * tD * (1- tax rate)  +  wP * rP  +  wE * rE

Where,

• w represents the weight of each component in capital structure
• r represents the cost of each component
• D, P and E represents debt, preferred stock and Common Equity respectively.

Cost of bond = 7%

Cost of preferred stock = 4/40  =  10%

Cost of Common Equity :

25 = 2  / (r - 0.07)

25 * (r - 0.07) = 2

25r - 1.75 = 2

25r = 2 + 1.75

r = 3.75 / 25

r = 0.15 or 15%

WACC = 0.4 * 0.07 * (1 - 0.4)  +  0.1 * 0.1  +  0.5 * 0.15

WACC = 0.1018 or 10.18%