Schadler Systems is expectedto pay a $3.50 dividend at year end (D 1 = $3.50), t

Question

Schadler Systems is expectedto pay a $3.50 dividend at year end (D1 = $3.50), thedividend is expected to grow at a constant rate of 6.50% a year,and the common stock currently sells for $62.50 a share. Thebefore-tax cost of debt is 7.50%, and the tax rate is 40%. Thetarget capital structure consists of 40% debt and 60% commonequity. What is the company's WACC if all equity is from retainedearnings? Schadler Systems is expectedto pay a $3.50 dividend at year end (D1 = $3.50), thedividend is expected to grow at a constant rate of 6.50% a year,and the common stock currently sells for $62.50 a share. Thebefore-tax cost of debt is 7.50%, and the tax rate is 40%. Thetarget capital structure consists of 40% debt and 60% commonequity. What is the company's WACC if all equity is from retainedearnings? 8.35% 8.70% 9.06% 9.42% 9.80%

Explanation / Answer

Expected Dividend(D1)       = $3.50

Dividend growthrate(g)        = 6.50%

Current price of the stock(P0) = $62.50

Before – Tax Cost of debt     = 7.50%

Rate or Return (R )     = (D1 / P0 ) + g

                                    = ($3.50 / $62.50) + 0.065

Rate of Return (R )     =  0.056 + 0.065

                                    = 0.121

Rate of Return (R )  =  12.1%

Component Cost of debt (kd) = kd (1-T)

                                         kd = 7.50%(1-0.4)

                                               = 0.075 * 0.6

                                               = 0.045 (or) 4.5%

Calculating Weighted Average Cost of Capital(WACC):

            WACC= wd kd (1-T) + wc ks

           WACC = (0.40*0.045 ) + (0.60 * 0.121)

                       = 0.018 + 0.0726

                       = 0.0906(or) 9.06%

           Weighted Average Cost of Capital(WACC) = 9.06%

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