Question

The following table gives Foust Company's earnings per share for the last 10 years. The common stock, 8.1 million shares outstanding, is now (1/1/20) selling for $70.00 per share. The expected dividend at the end of the current year (12/31/20) is 50% of the 2019 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.)

Year	EPS		Year	EPS
2010	$3.90		2015	$5.73
2011	4.21		2016	6.19
2012	4.55		2017	6.68
2013	4.91		2018	7.22
2014	5.31		2019	7.80

The current interest rate on new debt is 11%; Foust's marginal tax rate is 25%; and its target capital structure is 40% debt and 60% equity.

1. Calculate Foust's after-tax cost of debt. Round your answer to two decimal places.

     %

   Calculate Foust's cost of common equity. Calculate the cost of equity as r_s = D₁/P₀ + g. Do not round intermediate calculations. Round your answer to two decimal places.

     %

2. Find Foust's WACC. Do not round intermediate calculations. Round your answer to two decimal places.

     %

Answer 1

a. after-tax cost of debt = before-tax cost of debt*(1-tax rate) = 11%*(1-0.25) = 11%*0.75 = 8.25%

current interest rate on new debt is before-tax cost of debt.

first we need to calculate g i.e. growth rate for cost of equity calculation.

g = (EPS 2019/EPS 2010)^{1/no. of years} - 1 = ($7.80/$3.90)^1/10 - 1 = 2^0.1 - 1 = 1.0717734625362931642130063250233 - 1 = 0.07177346253629316421300632502334 or 7.1773462536293164213006325023342%

Cost of equity = [current dividend*(1+growth rate)/Current stock price] + growth rate

Cost of equity = [($7.80*50%)*(1+0.07177346253629316421300632502334)/$70] + 0.07177346253629316421300632502334 = [($3.9*1.07177346253629316421300632502334)/$70] + 0.07177346253629316421300632502334 = ($4.179916503891543340430724667591/$70) + 0.07177346253629316421300632502334 = 0.05971309291273633343472463810844 + 0.07177346253629316421300632502334 = 0.1315 or 13.15%

b. WACC = weight of debt*after-tax cost of debt + weight of equity*cost of equity

WACC = 0.40*8.25% + 0.60*13.15% = 3.3% + 7.89% = 11.19%