Question

Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The company's long-term bonds have a before-tax yield to maturity of 8.4 percent. The company uses the DCF approach to determine the cost of equity. Flaherty's common stock currently trades at $45 per share. The year-end dividend (D 1) is expected to be $2.50 per share, and the dividend is expected to grow forever at a constant rate of 7 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 10 percent, and the company's tax rate is 40 percent. What is the company's weighted average cost of capital, WACC? A. 10.30% B. 10.73% C. 7.48% D. 9.89% E. 11.31%

Answer 1

Answer:

Option B is correct

WACC= 10.73%

Explanation:

Weighted average cost of capital is the average cost of all of the long-term types of finance used by a company weighted according to the that amount of finance used in relation to the total pool of fund

WACC = (Wd×Kd) + (We×Ke)

After-tax cost of debt = Before tax cost of debt× (1-tax rate)

Kd-After-tax cost of debt  

Ke-Cost of equity  

Wd-Weight f debt  

We-Weight of equity  

After tax cost of debt = (1-T)× Before-tax yield on debt

                                 = (1-0.4)× 8.4

                                =5.04%

Cost of equity = Do/P(1-F) + g

D= Year 1 dividend= 2.50

P- price of stock = 45, F= Flotation cost= 10%, g= growth rate= 7%

Cost of equity =( 2.50/[(1-0.07)× 45]) + 0.07= 13.2%

WACC = (Wd×Kd) + (We×Ke)

We= 70%, Wd= 30%

WACC= (13.2%× 70%) + (5.04%× 30%)

         = 10.73%

WACC= 10.73%