Problem 5 Suppose you are informed that a company expects to pay a $2.50 dividen

Question

                    Problem 5                 

                    Suppose you are informed that a company expects to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow                     at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The                     target capital structure consists of 45% debt and 55% common equity. What is the company

Explanation / Answer

P0 = D1/(Re-g)

52.5 = 2.5(Re-0.055)

Re = 21.055%

POST TAX COST OF DEBT i.e. Kd = 7.5(1-0.4) = 4.5%

GIVEN:

Wd = 0.45

We = 0.55

THEREFORE WACC = We*Ke + Wd*Kd

=0.55*21.055 + 0.45*4.5

=13.61%

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