A large for profit group practicehas dividends that are expected to grow at a co

Question

A large for profit group practicehas dividends that are expected to grow at a constant rate of 7%per year into the foreseeable future. The firm's last dividend (D0)was $2, and its current stock price is $23. The beta coefficient ofthe firm is 1.6; the rate of return on 20-year T-bonds currently is9%; the expected rate of return is 13%. The firm's target capitalstructure calls for 50% debt financing, the interest rate requiredon the business's new debt is 10% and its tax rate is40%

1. Calculate the firm’sestimate for corporate cost of capital.

Explanation / Answer

Given Data:

           Company’s Capital structures are --- 50% Debt Financing

                                                                  ---50% Equity Financing

           Cost of debt before tax = 10%

           Risk- free rate (R f) = 9%

           Expected Rate of Return (Rm) = 13%

          Common stock beta = 1.6

           Tax rate = 40%

           Dividend Growth Rate (g) = 7%

           Last dividend (D0) = $2

           Expected Dividend (D1) = D0 (1+g)]

           Expected Dividend (D1) = $2 (1+0.07)

           Expected Dividend (D1) = $2.14

           Current Stock Price (P0) = $23

Calculate the Cost of Equity (RE) UsingDCF Method:

                       RE = (D1 / P0) + g

                        RE = ($2.14 / $23) + 0.07

                       RE = 0.1630 (or) 16.30%

           Cost of Equity (RE) = 16.30%

Calculation of Cost of equity(RE):

       (usingCAPM)

Cost of equity (R E) = R f + B * (Rm – R f)

                                 = 9% + 1.6(13% - 9%)

                                 = 0.09 + 1.6* 0.04

                                 = 0.09 +0.064

                                 = 0.154 (or)15.40%

Cost of equity (R E) =15.40%

Averaging the two:

           Cost of Equity (RE) = [(0.1540 + 0.1630) / 2]

Cost of Equity (RE) = 0.1585 (or)15.85%

Calculation Company’s after-tax cost ofdebt:

After-tax cost of debt = before-tax rate * (1- marginal taxrate)

                                   = 10% * (1-40%)

                                   = 0.10 * 0.6

                                   = 0.06 (or) 6%

After-tax cost of debt (RD) =6%

Calculation of weighted average cost of capital(WACC):

WACC = (E/V) * RE + (D/V) * RD (1-Tc)

            = 0.5 * 15.85% + 0.5 * 6%

            = 0.5 * 0.1585 + 0.5 * 0.06

            = 0.07925 + 0.03

            = 0.10925 (or) 10.925%

Weighted Average Cost of Capital (WACC) =10.925%

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