Question

Please Use TI BAII Plus Calculator and Show How You Get the Answer with it.

Management of the SoSadItIsOver Company needs to determine its cost of capital in order to evaluate some large capital purchases. The company's bonds have a yield to maturity of 6%, last dividend paid on common stock was $2.16 per share, current stock price is $47/share, and constant growth of 5% is expected on dividends and earnings. The company's capital structure is 30% debt, 70% equity. There is no preferred stock and the marginal tax rate is 21%.   SHOW ALL WORK.
a) 2 pts. What is the after-tax cost of debt?
b) 4 pts. What is the cost of equity?
c) 6 pts. What is the company's cost of capital (WACC)?

Answer 1

a.The question is solved by first calculating the after tax cost of debt.

After tax cost of debt= Before tax cost of debt*(1 – tax)

                                        = 6%*(1 – 0.21)

                                        = 6%*0.79

                                        = 4.74%

b.Information provided:

Last dividend payment= $2.16

Current stock price= $47

Growth rate= 5%

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= $2.16*(1 + 0.05)/ $47 + 0.05

     = $2.2680/ $47 + 0.05

     = 0.0483 + 0.05

     = 0.0983*100

     = 9.83%

c.The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+ We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.30*4.74% + 0.70*9.83%

            = 1.4220% + 6.8810%

            = 8.3030%   8.30%

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