Question

1A. An analyst has collected the following information regarding Christopher Co.: · The company's capital structure is 70 percent equity, 30 percent debt. · The yield to maturity on the company's bonds is 4 percent. · The company's year-end dividend (D1) is forecasted to be $1.0 a share. · The company expects that its dividend will grow at a constant rate of 4 percent a year. · The company's stock price is $25. · The company's tax rate is 40 percent. · The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company's WACC in percentage. Round it to two decimal places.

1B. New Mexico Lumber recently reported that its earnings per share were $3 .00. The company has 300,000 shares of stock outstanding. The company's interest expense was $ 600,000. The corporate tax rate is 40 percent. What was the company's operating income (EBIT)? Round it to a whole dollar, and do not include the dollar sign.

Answer 1

Greetings,

(1A) Calculation of WACC -

Post tax cost of debt = 4% * (1-0.4) = 2.4%

Cost of Equity is the sum total of the dividend yield and capital gains yield.

Where dividend yield = expected dividend next year/ price of the share today = 1/25*100 = 4%

Capital gains yield = growth rate of dividend = 4%

Therefore Cost of Equity = 4+4=8%

This is before considering floatation costs. Since FC is 10% of Issued capital, it means we will get 90 on every 100 issued capital.

Therefore FC = 10/90*8%=0.89%

Hence Cost of Equity = 8+0.89=8.89%

Given Weight of debt = 0.3 And Equity = 0.7, WACC = (2.4*0.3)+(8.89*0.7) = 6.94% (approx)

(1B) Calculation of EBIT -

EPS = 3/share Shares Outstanding = 300000

Therefore Earnings after tax = 3*300000 = 900000

Add - Tax @ 40% = 900000/0.6*0.4 = 600000*

Earnings before Tax = 1500000

Add - Interest Expense = 600000

Operating Income (EBIT) = . 2100000

* tax calculation

Since 900000 is profit after tax, it means it represents only 60% of the profit before tax as tax was 40%. So to make it pre tax, we need to divide it by 0.6. Tax is therefore 40% of the pre-tax amount.