Question

Calculate WACC as required return from the following:
100 million common shares trading at $90 per share
Historical dividend at $0.50 per share, however expected to increase to $2.25 per share in next period.
2.5 million preferred shares that get $20M in dividends, and currently trading at $100 per share
Based off last year's earnnings, %10 was given out as dividends and expected to remain steady in subesquent years
Determine the cost of equity using 2017 net income divided by average two-year shareholder's equity to calculate the roe as part of calculation
Total market value of debt is 3.5B, which includes an additional $1.5Bto be taken on that's not included in the current finc statements below.
before tax cost of debt is approximately %4
Determine the after-tacx cost of debt to be used in the WACC
use a tax rate of %25 for this analysis.
cost of equity - use 2017 net income ($704M) div by average two year shareholder's equity - ROE Shareholder's Equity Common Shares $1,000 $1,000 $1,000 $1,000 $1,000 Preferred Shares $250 $250 $250 $250 $250 Retained Earnings $2,038 $3,605 $4,691 $5,665 $6,299 Total Equity $3,288 $4,855 $5,941 $6,915 $7,549

Original question:

Weighted Average Cost of Capital (WACC)

Mr. Stark wants you to use the weighted average cost of capital (WACC) as the required return. CHI currently has 100 million common shares that are trading at $90 per share. The dividend has historically been $0.50 per share, but is expected to increase to $2.25 per share in the next period. CHI also has 2.5 million preferred shares that get $20M in dividends and are currently trading at $100 per share. Based off of last years' earnings, the amount of earnings given out as dividends was around 10%, and this is expected to remain steady in subsequent years. Mr. Stark wants you to determine the cost of equity, using 2017's net income divided by average two-year shareholder's equity to calculate the return on equity as part of the calculation.

The total market value of debt CHI is expected to have going into this investment is $3.5B, which includes the additional $1.5B to be taken on that is not included in the current financial statements. The before-tax cost of debt is approximately 4%. Mr. Stark needs you to determine the after-tax cost of debt to be used in the WACC. A tax rate of 25% has been suggested for use in the analysis.

Answer 1

Shareholder's Equity
Common Shares	$1,000	$1,000	$1,000	$1,000	$1,000
Preferred Shares	$250	$250	$250	$250	$250
Retained Earnings	$2,038	$3,605	$4,691	$5,665	$6,299
Total Equity	$3,288	$4,855	$5,941	$6,915	$7,549
Increase in retained earnings	-	$1,567	$1,086	$974	$634
Net income (retained earnings/ 90%)	$2,264	$4,006	$5,212	$6,294	$6,999
Growth rate of net income		76.89%	30.12%	20.76%	11.19%

WACE calculation
Type of capital	No of shares	Share price	MV	% of total capital	Model used	Cost of capital	Formula	Cost of weighted capital
Common shares	100,000,000	90	9,000,000,000	57.88%	DDM	2.50%	=2.25/90	1.45%
Preferred shares	2,500,000	100	250,000,000	1.61%	DDM	8.00%	=(20/2.5)/100	0.13%
Retained earnings	-	-	6,299,000,000	40.51%	growth rate of income	11.19%	=(6999/6294)-1	4.53%
Total			15,549,000,000	100.00%				6.11%

Pre-tax interest rate on debt	4.0%
Effective tax rate	25.0%
After-tax cost of debt	3.0%	=4%*(1-25%)

WACC calculation
Type of capital	MV	% of total capital	Cost of capital	Cost of weighted capital
Equity	15,549,000,000	81.63%	6.11%	4.99%
Debt	3,500,000,000	18.37%	3.00%	0.55%
Total	19,049,000,000	100.00%		5.54%

Hence, the WACC for CHI is 5.54%.