Question

Columbia Gas Company’s (CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If CG’s long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%. Select one: a. .a. 10.9% b. c. 19.6% c. b. 13.6% d. d. 16.9%

Answer 1

Answer:

Current dividend per share paid (Do)

= Total dividend

  No of shares outstanding

= $1,600,000

   1,000,000 shares

= $1.60 per share

Current market price = $31

Growth rate = 8%  = 0.08

Ke = Do(1 + g)  + g

               Po

Ke = $1.60(1 + 0.08) + 0.08

                     $31

Ke = 0.1357 = 13.57%

Interest rate on borrowing (Kd) = 10%

Tax rate (T) = 40% = 0.40

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

WACC = 13.57(65/100) + 10(35/100)(1 - 0.4)

WACC = 8.82 + 2.10

WACC = 10.9%

The correct answer is A

Explanation:

In this case, we need to calculate cost of equity. The cost of debt has been given, which is the interest rate on long-term borrowing (10%). Since the debt proportion in the capital structure is 35% and equity proportion is 65%, it implies that the value of the firm is 100%.  Then, WACC is the aggregate of cost of each stock and the proportion of each stock in the capital structure.