Question

Vanessa Inc has a beta of .7. The market risk premium is 8% and risk-free rate is 5%.   Vanessa Inc’s last dividend was $1.20 per share, and the dividend is expected to grow at 7% indefinitely. The stock price is currently $40.   Vanessa Inc’s target capital structure is 30% debt and 70% equity. It cost of debt is 10% before taxes. The tax rate is 40%.

a) Calculate the cost of equity under:

1. The dividend growth
2. CAPM
3. Average of the two approaches

b) Using the average cost of equity calculated previously, what is the WACC

Answer 1

(a) Calculate the cost of equity under:

The Cost of Equity under dividend growth model

The Cost of Equity under dividend growth model = [D1 / P0] + g

= [D0(1 + g) / P0] + g

= [$1.20(1 + 0.07) / $40] + 0.07

= [$1.2840 / $40] + 0.07

= 0.0321 + 0.07

= 0.1021 or

= 10.21%

The Cost of Equity under CAPM approach

The Cost of Equity under CAPM approach = Risk-free rate + [Beta x Market risk premium]

= 5.00% + [0.70 x 8.00%]

= 5.00% + 5.60%

= 10.60%

The Average of the two approaches

The Average of the two approaches = [Cost of Equity under dividend growth model + Cost of Equity under CAPM approach] / 2

= [10.60% + 10.21%] / 2

= 20.81% / 2

= 10.41%

(b)-The Weighted average cost of capital (WACC)

The Weighted average cost of capital (WACC) = [After-tax cost debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [$10.00(1 – 0.40) x 0.30] + [10.41% x 0.71]

= [6.00% x 0.30] + [10.41% x 0.70]

= 1.80% + 7.29%

= 9.09%