Despite group of companies is a rapidly growing chain of retail outlets offering

Question

Despite group of companies is a rapidly growing chain of retail outlets offering brand name merchandise at discount price.A security analysts report issued by a national brokerage firm indicates that debt-yielding 10% compose 60% of the companys overall capital structure.Furthurmore, both earnings and dividends are expected to grow at 10% per year.Currently, common stock in the company is priced at gh$ 30 and it should pay gh$ 1.6 per share in dividend during the coming year. This yeild compares favourably with the 8% return currently available on risk free securities and the 16% average for all common stocks. Given the companys estimated Beta (b)= 1.2.

a) calculate the companys component cost of equity using CAPM

b) Assuming a 40% marginal income tax rate, calculate the companys WACC

Explanation / Answer

(a) CAPM Cost of Equity, ke = Risk free rate + [Beta x (Market return - Risk free rate)]

= 8% + [1.2 x (16% - 8%)]

= 8% + 9.6% = 17.6%

(b)

Post tax cost of debt, kd = Interest rate x (1 - tax rate)

= 10% x (1 - 0.40) = 6%

So, WACC = ke x Proportion of equity + kd x Proportion of debt

= (17.6% x 40%) + (6% x 60%) **

= 7.04% + 3.6% = 10.64%

** Since debt comprises 60% of overall capital, equity comprises 40% (Balance).

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