Biogenetics Corporation has a target capital structure of 55 percent equity. The

Question

Biogenetics Corporation has a target capital structure of 55 percent equity. The firm just paid dividends of $1.5 per share and dividends are expected to growth at 10 percent a year. Biogenetics YTM bonds are 7.5 percent, and the company is now on the 35 percent tax rate. On last trading day, Biogenetics stock was selling at $30.

a. What is Biogenetics WACC? Show Calculation

b. The company president has approached you about the company capital structure. He wants to know why the company doesn’t use more stock financing, since it costs less than debt. What would you tell the president?

Explanation / Answer

WACC = Weight Of Equity * Equity Rate + Weight Of Debt * Debt Cost

Equity Rate = D1 / P + g

Or Equity Rate = D0( 1+g) / P + g

= 1.5*1.1/30 + 0.10

Solving above we get, equity required return = 15.5%

Debt Cost = 7.5( 1- 0.35) = 4.875%

Weight of equity = 0.55 ; Weight of Debt = 1 -0.55 = 0.45

WACC = 0.55 * 15.5% + 0.45 * 4.875% = 8.525% + 2.19375% = 7.07%

Clearly, cost of debt is much less than cost of equity. We can see that at 100% debt level, WACC would be 4.875% and just when equity is increased , WACC also increases. Thus it is not sensible to use equity financing when debt is available so cheaply. Moreover, to magnify equity returns, higher debt component would lead to lower interest costs, thereby increasing equity return. This concept is known as leverage

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