Question

Growth​ Company's current share price is $19.95 and it is expected to pay a $ 1.05 dividend per share next year. After​ that, the​ firm's dividends are expected to grow at a rate of 4.4% per year. a. What is an estimate of Growth​ Company's cost of​ equity? b. Growth Company also has preferred stock outstanding that pays a $2.15 per share fixed dividend. If this stock is currently priced at $ 28.05, what is Growth​ Company's cost of preferred​ stock? c. Growth Company has existing debt issued three years ago with a coupon rate of 6.3%. The firm just issued new debt at par with a coupon rate of 6.6%. What is Growth​ Company's cost of​ debt? d. Growth Company has 4.8 million common shares outstanding and 1.1 million preferred shares​ outstanding, and its equity has a total book value of $50.3 million. Its liabilities have a market value of $19.6 million. If Growth​ Company's common and preferred shares are priced as in parts ​(a​) and ​(b​), what is the market value of Growth​ Company's assets? e. Growth Company faces a 38% tax rate. Given the information in parts (a) through (d), and your answers to those​ problems, what is Growth​ Company's WACC?

​Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

1. Given Information

Current Share Price = P₀ = $19.95 per share

Dividend next year = D₁ = $1.05 per share

Growth rate = g = 4.4%

Cost of equity = r_e = ?

Using the formula

P₀ = D₁ / (r_e – g)

=> r_e = (D₁/P₀) + g = (1.05/19.95) + 0.044 = 9.66%

1. Given -

Preference Dividend (D_ps)= $2.15 per share

Current market price of preference share (MV_ps) = $28.05 per share

Cost of preference share (r_ps)= D_ps / MV_ps = 2.15 / 28.05 = 7.66%

1. Recent debt was issued at par with a coupon rate of 6.6%. Recent debt is more representative of current costs of debt as compared to debt issued three years ago.

So, Cost of debt (r_d) = 6.6%

1. By accounting equation

Assets = Equity + Liability

So Market Value (MV) of Assets = Market Value of (Common Stock + Preference Shares + Debt )

MV (Assets) = (4.8 m shares *19.95 per share) + (1.1 m preference shares * 28.05 per preference share) + (19.6 m)

MV (Assets) = 95.76 + 30.86 + 19.60

MV (Assets) = $146.22 million

1. Given –

Tax Rate = 38%

Formula for WACC

WACC = W_d * (r_d * (1-Tax)) + W_ps * r_ps + W_e * r_e

W_d,W_ps &W_e – Weights of debt, preference shares & equity shares, respectively

r_d,r_ps & r_e   - Required returns debt, preference shares & equity shares, respectively

Total Market Value = $146.22

Hence, W_d = 19.6 / 146.22 =13.40%

W_ps = 30.86 / 146.22 =21.10%

W_e = 95.76 / 146.22 =65.49%

Hence, WACC = W_d * (r_d * (1-Tax)) + W_ps * r_ps + W_e * r_e

WACC = 0.134 * (6.6% * (1-0.38)) + 0.211 * 7.66% + 0.6549 * 9.66%

WACC = 8.49%