Calculate the company\'s weighted average cost of capital (WACC) under the follo

Question

Calculate the company's weighted average cost of capital (WACC) under the following assumption provided by Sur. The company's long-term bends currently offer a yield to maturity of 8 percent. The company's stock price is $50 share (P0 = $50). The company recently paid a dividend of $2 per share (D) = $2.00). The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%). The company's target capital structure is 75 percent equity and 25 percent debt. The company's tax rate is 40 percent. How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC? Concept Check: The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of dept. Another way of looking at this is computing the effect of the capital structure on expected returns by investors. WACC = (E/V)x r_a + (D/V) x Rd x (1-Tc)

Explanation / Answer

After tax cost of debt Kd = Rd x (1-t)

                                                = 8% x (1-0.40)

                                                = 4.80%

Cost of equity Ke = Do x (1+g)/P   + g

                                   = 2 x (1+0.06)/50 + 0.06

                                    = 0.0424+0.06

                                     = 10.24%

WACC = We x Ke + Wd x Kd

                = 0.75 x10.24% + 0.25 x4.80%

                = 7.68% +1.20%

                = 8.88%

WACC is the overall cost of capital of the firm. it helps in comparing return from the project and selecting the best project.

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