Question

Frankenstein Electric has a capital structure that consists of 60 percent equity and 40 percent debt. The company's long-term bonds have a before-tax yield to maturity of 7 percent. The company uses the DCF approach to determine the cost of equity. Frankenstein's common stock currently trades at $40 per share. The year-end dividend is expected to be $2 per share, and the dividend is expected to grow forever at a constant rate of 9 percent a year. The company estimates that it will have to issue new common stock to help fund this year's projects. The flotation cost on new common stock issued is 15 percent, and the company's tax rate is 40 percent. What is the company's weighted average cost of capital, WACC?A. 11.7%B. 10.1% C. 8.9% D. 11.0% E. 10.6%

Answer 1

Answer:

Kd = 7%

Ke =      D1      +  g

        Po(1 - FC)

Ke =      $2            + 0.09

        $40(1 - 0.15)

Ke =       $2      +  0.09

              $34

Ke = 0.1488 = 14.88%

WACC = Ke(E/V) + Kd(D/V)(1-T)

WACC = 14.88(60/100) + 7(40/100)(1 - 0.40)

WACC = 8.928 + 1.68

WACC = 10.6%

Explanation:

In this case before-tax cost of debt is given. Cost of equity is expected dividend divided by current market price after flotation cost plus growth rate. WACC is calculated as cost of equity multiplied by the proportion of equity in the capital structure plus after-tax cost of debt multiplied by proportion of debt in the capital structure.