Question

The Black Knight has a debt-equity ratio of .6, a beta of 1.12, a stock price of $42 a share, and a tax rate of 34 percent. The firm just paid an annual dividend of $.80 a share and plans to increase that amount by 3 percent annually in the future. The firm has a pre-tax cost of debt of 7.7 percent. The risk-free rate is 3.8 percent and the market rate of return is 8.4 percent. What is Black Knight’s WACC?

a. 6.08 percent

b. 6.25 percent

c. 7.15 percent

d. 7.24 percent

Answer 1

Information provided:

Debt equity ratio= 0.6%

Beta= 1.12

Stock price= $42

Current stock dividend= $0.80

Dividend growth rate= 3%

Pretax cost of debt= 7.7%

Risk free rate= 3.8%

Market rate of return= 8.4%

Tax rate= 34%

The cost of equity is calculated using the capital asset pricing model and dividend discount model.

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+b[E(Rm)-Rf]

Where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 3.8% + 1.12*(8.4% - 3.8%)

     = 3.8% + 5.1520%

     = 8.9520%  

The cost of equity is calculated using the dividend discount model. It is calculated using the below formula:

Ke=D1/Po+g

Where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= $0.80*(1 + 0.03)/ $42 + 0.03

     = $0.8240/ $42 + 0.03

     = 0.0196 + 0.03

     = 0.0496*100

     = 4.9619%

Cost of equity= 8.9520% + 4.9619%/2

                           = 6.9570%

Weighted average cost of capital is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= (0.60/1.60)* 7.7%*(1 – 0.34) + (1/1.60)* 6.9570%

             = 1.9058% +4.3481%

             = 6.2539%      6.25%

Hence, the answer is option b.

In case of any query, kindly comment on the solution.