below (in million EUR): EBIT Interest expense Earnings before taxes (EBT) Taxes
ID: 2792656 • Letter: B
Question
below (in million EUR): EBIT Interest expense Earnings before taxes (EBT) Taxes Net income 130 30 100 25 75 The company has 10 million shares outstanding. The shares are currently trading at the level of P/E (price earnings ratio)-12 times. The company has released the following forecasts: 80% of net income will be paid out as dividends in the future. Expected (long-term) growth rate of both net income and dividends is 3% annually. The company also uses bank financing quite extensively. The level of debt has been quite stable recently and has remained at the level of 600 million EUR for quite some time. The company is going to issue new debt if necessary in order to maintain the current level of leverage. Questions: b) Find the cost of equity and debt c) Find the market value weights for both sources of capital d) Calculate the after-tax cost of capital (WACC) and explain briefly what does this result mean?Explanation / Answer
b) Current Stock Price = PE x EPS
Here, PE - Price earning ratio = 12, EPS - Earnings per share = Net Income / No. of shares = 75 / 10 = 7.5
=> Price, P = 12 x 7.5 = 90
Dividend per share, D0 = EPS x payout ratio = 7.5 x 80% = 6.0
Using DCF, Cost of equity, re = D0 x (1 + g) / P + g = 6 x 1.03 / 90 + 3% = 9.87%
Cost of debt, rd = Interest expense / Debt = 30 / 600 = 5%
c) Market Value of equity = 10 x 90 = 900 million
Market Value of debt = 600 million
Total Value = 1,500 million
Weight of equity, we = 900 / 1500 = 60%
Weight of debt, wd = 600 / 1500 = 40%
d) WACC = we x re + wd x kd x (1 - tax)
= 60% x 9.87% + 40% x 5% x (1 - 25%)
= 7.42%
WACC is the weighted average cost of capital given the current market environment. It is also the hurdle for investment projects. If a firm identifies an investment opportunity with rate of return higher than WACC, then they would invest in the project.
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