Question

Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50 percent common stock. · The company can issue bonds at a yield to maturity of 8.8 percent. · The cost of preferred stock is 8 percent. · The company's common stock currently sells for $30 a share. · The company's dividend has just paid $2.00 a share (D0 = $2.00), and is expected to grow at a constant rate of 7 percent per year. · Assume that the flotation cost on debt and preferred stock is zero, and no new stock will be issued. · The company's tax rate is 30 percent. What is the company's weighted average cost of capital (WACC)? Express your answer in percentage (without the % sign) and round it to two decimal places.

Answer 1

Company’s Weighted Average Cost of Capital (WACC)

After Tax Cost of Debt

After Tax Cost of Debt = Yield to maturity of the Bond x (1 – Tax rate)

= 8.80% x (1 – 0.30)

= 8.80% x 0.70

= 6.16%

Cost of Preferred stock = 8.00%

Cost of equity

Here, we have Dividend per share in year 0 (D0) = $2.00 per share

Dividend Growth Rate (g) = 7.00% per year

Current market price of the stock (P0) = $30.00 per share

As per the Discounted cash flow (DCF) method, the Cost of equity is calculated as follows

Cost of equity = [D1 / P0] + g

= [D1(1 + g) / P0] + g

= [$2.00(1 + 0.07) / $30.00] + 0.07

= [$2.14 / $30.00] + 0.07

= 0.0713 + 0.07

= 0.1413 or

= 14.13%

Weight of Debt = 0.40 or 40%

Weight of Preferred Stock = 0.10 or 10%

Weight of Equity = 0.50 or 50%

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [6.16% x 0.40] + [8.00% x 0.10] + [14.13% x 0.50]

= 2.46% + 0.80% + 7.07%

= 10.33%

“Hence, the Company’s Weighted Average Cost of Capital (WACC) will be 10.33%”