Touring Enterprises, Inc., has a capital structure consisting of $18 million in

Question

Touring Enterprises, Inc., has a capital structure consisting of $18 million in long-term debt and $7 million in common equity. There is no preferred stock outstanding.

The interest rate paid on the long-term debt is 10%. The firm is in the 35% tax bracket.

On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.

Based on this information, answer the following questions:

1. Calculate Touring Enterprises' weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity. Cite both formulas, and show all your work.

Then, determine the weightings of debt and equity in the capital structure.

Lastly, using your answers to the above questions, calculate the WACC.

Explanation / Answer

Touring Enterprises, Inc., has a capital structure consisting of $18 million in long-term debt and $7 million in common equity. There is no preferred stock outstanding.    The interest rate paid on the long-term debt is 10%. The firm is in the 35% tax bracket.    On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.     Based on this information, answer the following questions:      

1. Calculate Touring Enterprises' weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity. Cite both formulas, and show all your work.            Then, determine the weightings of debt and equity in the capital structure.            Lastly, using your answers to the above questions, calculate the WACC.   

After-tax cost of debt= (wd) x (kd) (1-T)

wd = Book Value of Debt / [Market Value of Equity + Book Value of Debt]
= 18/(7+18)x 100% = 72%

kd = 10%
T = 35% = 0.35
after-tax cost of debt = (72%)x (10%)(1-.35) = 4.68%

cost of equity ks=d1/po + g

For Touring Enterprises, Inc., d1= 1.20% + 5% of dividend rate
= 1.20% + 0.06% = 1.26%
cost of common equity ks = 1.26/50 +5% =7.52%

weight of debt.we = Market Value of Equity / [Market Value of Equity + Book Value of Debt]
= 7/(7+18)x 100% = 28%

WACC=wd x kd(1-t) + (we)(ks)
= (72%)*(10%)(1-.35) + 28%*7.52%
= 4.68%+2.1056% == 6.7856%

2. If Touring Enterprises were to increase the percentage of debt in its capital   INCREASE

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