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, 7.4 million shares outstanding, is now (1/1/09) selling for $80 per share, and the expected dividend at the end of the current year (12/31/09) is 45% of the 2008 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.)


Year/EPS

1999,$3.90
2000,$4.21
2001,$4.55
2002,$4.91
2003, $5.31
2004, $5.73
2005,$6.19
2006,$6.68
2007,$7.22
2008, $7.80

The current interest rate on new debt is 8%, Foust's marginal tax rate is 40%, and its capital structure, considered to be optimal, is as follows:

Debt $118,000,000
Common Equity $147,000,000
Total Liabilities and equity $265,000,000


a. Calculate Foust's after-tax cost of debt. Round your answer to two decimal places.
_________%

b. Calculate Foust's after-tax cost of common equity. Calculate the cost of equity as rs = D1/P0 + g. Round your answer to two decimal places.
___________%

c. Find Foust's WACC. Round your answer to two decimal places.
_______________ %

Explanation / Answer

According to the given information, Common shares outstanding = 7,400,000 Current price of common share = $80 Expected dividend (D1) = 45% of 2008 EPS According to the given data of EPS, the growth rate is constant and it is comes to 8%. If we consider any of the years, then the growth rate comes to EPS growth rate = (EPS in 2000 - EPS in 1999) / EPS in 1999                             = ($4.21 - $3.90) / $3.9                            = $0.31 / $3.9                            = 0.08 or 8% Therefore, the growth rate comes to 8% Similary, if we calculate the growth rate for the next years we get the same value of 8% The current interest rate on new debt = 8% Marginal tax rate = 40% Weight of debt = $118,000,000 / $265,000,000                           = 0.4453 or 44.53% Weight of equity = $147,000,000 / $265,000,000                               = 0.5547 or 55.47% a) Calculating the after-tax cost of debt: We know that the cost of debt is 8% which is nothing but the current interest rate on the debt. After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                      = 8% (1 - 0.40)                                      = 0.08 (0.60)                                      = 0.048 or 4.80% Therefore, the after-tax cost of debt is 4.80% b) Calculating the after-tax cost of common equity: According to Dividend growth model, the cost of common equity is calculated as                            Cost of equity = (D1 / P0) + g where D1 = 45% ($7.80)                   = $3.51            P0 = $80            g = 8% Substituting the values in the above formula, we get                               Cost of equity = ($3.51 / $80) + 0.08                                                        = 0.043875 + 0.08                                                        = 0.1239 or 12.39% Therefore, the cost of common equity is 12.39% Note that common dividends are not tax deductible, so there is no adjustment for the cost of common equity. c) Calculating the WACC usingt the formula: The formula for calculating the WACC is                     WACC = (Wd x Rd) + (We x Re) where Wd is the weight of debt             Rd is the after-tax cost of debt             We is the weight of equity              Re is the cost of equity                            WACC = (0.4453 x 0.048) + (0.5547 x 0.1239)                                         = 0.02137 + 0.06873                                         = 0.0901 or 9.01% Therefore, the value of WACC is 9.01%

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