Allison Engines Corporation has established a target capital structure of 40% de

Question

Allison Engines Corporation has established a target capital structure of 40% debt and 60% common equity. The current market price of the firm's stock is P0 = $36; its last dividend was D0 = $2.80, and its expected dividend growth rate is 8%. Allison must issue new common stock at a flotation cost of 10%. Find: 1. What is Allison's cost of new outside equity capital, i.e., cost of new equity? 2. Given a cost of new debt of 8%, find Allison's WACC. Helpful hints: Tax Rate is 40%; use constant growth formula to find Rs

Explanation / Answer

1.

D0=$2.8

D1 = 2.8*(1.08) = $3.024

ke=D1/P0 + g

= 3.024/36 + 0.08 = 16.4%

floatation cost = 10%

means new share price will be $36, but company will get (36 - 10%of 36) = (36-3.6) = $32.4

so new cost of equity ke=3.024/32.4+0.08 = 17.33%

2.

cost of debt=8%

WACC = .4*8 + .6*17.33 = 13.6%

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