Question

Dobson Dairies has a capital structure which consists of 60% long-term debt and 40% common stock. The company’s CFO has obtained the following information:

• The before-tax yield to maturity on the company’s bonds is 8%.
• The company’s common stock is expected to pay a $3.00 dividend at year end (D₁ = $3.00), and the dividend is expected to grow at a constant rate of 7% a year. The common stock currently sells for $60 a share.
• Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
• The company’s tax rate is 35%.

What is the company’s weighted average cost of capital (WACC)?

Answer 1

Market price per share=   60  
D1=   3  
Growth rate=   7%  
Cost of retained earnings = (D1/P0)+g      
(3/60)+7%      
12.00%      
Cost of Retained Earnings (Equity) for budget is   12.00%  
      
Before tax yield =   8%  
Aftertax cost of debt = before tax yield*(1-tax rate)      
8%*(1-35%)      
5.20%      
      
Weight of debt=   60%  
weight of Equity=   40%  
      
WACC = (weight of debt * cost of debt) + (weight of Equity * cost of Equity)      
(60% * 5.2%)+(40%*12%)      
0.0792 or 7.92%      
      
so wacc is    7.92%