10-2: Basic Definitions 10-5: The Cost of Retained Earnings, rs WACC and Percent

Question

10-2: Basic Definitions 10-5: The Cost of Retained Earnings, rs WACC and Percentage of Debt Financing Hook Industries' capital structure consists solely of debt and common equity. It can issue debt at rd = 11%, and its common stock currently pays a $3.50 dividend per share (Do-$3.50). The stock's price is currently $27.75, its dividend is expected to grow at a constant rate of 5% per year, its tax rate is 40%, and its WACC is 12.00%, what percentage of the company's capital structure consists of debt? Round your answer to two decimal piaces.

Explanation / Answer

Cost of equity=(Dividend for next period/Current price)+Growth rate

=(3.5*1.05)/27.75+0.05

=0.182432432

Cost of debt after tax=11(1-0.4)=0.066

Let debt be $x

Equity be $y

Total=$(x+y)

WACC=Respective costs*Respective investment weights

0.12=(0.182432432y/(x+y))+(0.066x/(x+y))

0.12(x+y)=0.182432432y+0.066x

0.12x+0.12y=0.182432432y+0.066x

Hence x=(0.182432432-0.12)y/(0.12-0.066)

=1.156156y(Approx)

Hence total=x+y

=2.156156y

Hence weight of debt=(1.156156y/2.156156y)

=53.62%(Approx).

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