Question

Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year is expected to be $500,000 and the firm's payout ratio is 60 percent. The firm's common equity ratio is 30 percent and it has no preferred stock outstanding. The firm can borrow up to $300,000 at an interest rate of 7 percent; any additional debt will have an interest rate of 9 percent. Your company's tax rate is 40 percent. If the firm has a capital budget of $1,000,000, what is the WACC for the last dollar of capital the company raises?
a. 9.94%
b. 11.81%
c. 6.76%
d. 13.25%
e. 3.78%

Answer 1

Answer:

C) 6.76%

Explanation:

cost of retained earnings = {[dividends (1 + growth rate)] / stock price} + growth rate = {[$2 x (1 + 5%)] / $50} + 5% = {($2 x 1.05) / $50} + 5% = ($2.10 / $50) + 5% = 4.2% + 5% = 9.42%

cost of new equity = {[dividends (1 + growth rate)] / [stock price x (1 - flotation cost)]} + growth rate = {[$2 x (1 + 5%)] / [$50 x (1 - 15%)]} + 5% = {($2 x 1.05) / ($50 x 85%)} + 5% = ($2.10 / $42.50) + 5% = 4.94% + 5% = 9.94%

cost of debt after tax (up to $300,000) = interest rate x (1 - tax rate) = 7% x (1 - 40%) = 7% x 60% = 4.2%

the company needs to raise $333,333 - available retained earnings $200,000 (= $500,000 x 40%) = $133,333

• 30% will come from new equity (equity ratio) = $40,000
• $93,333 will come from new debt

WACC = [(cost of debt x $93,333) / $133,333] + [(cost of new equity x $40,000) / $133,333] = [(5.4% x $93,333) / $133,333] + [(9.94% x $40,000) / $133,333] = ($5,040 / $133,333) + ($3,976 / $133,333) = 3.78% + 2.98% = 6.76%