The following table gives Foust Company\'s earnings per share for the last 10 ye

Question

The following table gives Foust Company's earnings per share for the last 10 years. The common stock, 7.8 million shares outstanding, is now (1/1/09) selling for $65.00 per share. The expected dividend at the end of the current year (12/21/09) is 55% of the 2008 EPS. Because investors expect past trends to continue, g may be based in the historical earnings growth rate (Note that 9 years of growth are reflected in the 10 years of data.)
Year EPS Year EPS
1999 $ 3.90 2004 $ 5.73
2000 4.21 2005 6.19
2001 4.55 2006 6.68
2002 4.91 2007 7.22
2003 5.31 2008 7.80

The current interest rate on new debt is 9%, Foust's marginal tax rate is 40%; and its capital structure, considered to be optimal, is as follows:
Debt 104000000
Common equity 156000000
Total liabilities and equity 260000000

a. Calculate Foust's after-tax cost of debt and common equity. Calculate the cost of equity as rs=D1/P0+ g.

b. Find Foust's WACC.

Explanation / Answer

a. Current year Dividend is 55% of the 2008 EPS.       Current year Dividend   = 0.55*7.80                                               = $4.29       Growth rate       = (P1 - P0)/P0                                  = (4.21 - 3.90)/3.90                                  = 8%. (Note: Here the P1 is 2000 EPS and P0 is 1999 EPS) Calculation of cost of debt:    Cost of debt after tax = Cost of debt*(1-Taxes)                                          = 9%* (1-0.4)                                          = 9%*0.6                                          = 5.4%.    Therefore the cost of debt after taxed is 5.4%. Calculation of cost of equity:                                  Cost of equity rs   = Dividend/Current market price of the share + Growth rate                                                                  = $4.29/$65 + 8%                                                                  = 0.066 + 0.08                                                                  =0.146 or (14.6%) Therefore the cost of equity is 14.6%. b. Calculation of WACC: Value of the firm is = 260,000,000 Value of debt is        = 104,000,000 Value of equity is     = 156,000,000 % of debt is              = Value of debt/Value of the firm                                    = 104,000,000/260,000,000                                    = 0.4 % of debt is              = Value of equity/Value of the firm                                    = 156,000,000/260,000,000                                    = 0.6       WACC       = Cost of debt after taxes* % of debt + Cost of equity*% of equity                          = 5.4% * 0.4 + 14.6%*0.6                          = 2.16% + 8.76%                          = 10.92%. Therefore the WACC is 10.92% Value of the firm is = 260,000,000 Value of debt is        = 104,000,000 Value of equity is     = 156,000,000 % of debt is              = Value of debt/Value of the firm                                    = 104,000,000/260,000,000                                    = 0.4 % of debt is              = Value of equity/Value of the firm                                    = 156,000,000/260,000,000                                    = 0.6       WACC       = Cost of debt after taxes* % of debt + Cost of equity*% of equity                          = 5.4% * 0.4 + 14.6%*0.6                          = 2.16% + 8.76%                          = 10.92%. Therefore the WACC is 10.92%

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