Debt and Common Equity are only used in this company. It can borrow unlimited am

Question

Debt and Common Equity are only used in this company. It can borrow unlimited amounts at an interest rate of 10% as long as it finances at its target capital structure which calls fo 45%debt and 55% common equity. It's last dividend as $2, its expected constant growth rate is 4%, and its common stock sells for $20. The tax rate is 40%. Project A has a rate of return of 13% and Project B has a retturn of 10%. These two projects are equally risky and about as risky as the firm's assets.

1) What is the company's expected growth rate?

2) If the firm's net income is expected to be $1.1 billion what portion of it's net income is the firm's expected to pay out as dividends?

Explanation / Answer

Cost of equity = D1 / P0 + G [ Where D1 = Expected Dividend,, P0 = Price of common stock and G = Growth rate]

= 2.08 / 20 + 0.04 [ Where D1 = 2 + 4 % = 2.08 ]

= 0.104 + 0.04

= 0.144 i.e., 14.4%

Cost of debt = 10 ( 1 - 0.40)

= 6 %

Weighted average cost of capital (WACC) = 0.45 * 6 + 0.55 * 14.4

= 2.7 + 7.92

= 10.62 %

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