Question

An analyst has collected the following information regarding Klondike Co.: · The company's capital structure is 75 percent equity, 25 percent debt. · The yield to maturity on the company's bonds is 8 percent. · The company's year-end dividend is forecasted to be $0.50 a share. · The company expects that its dividend will grow at a constant rate of 5 percent a year. · The company's stock price is $20. · The company's tax rate is 35 percent. · The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 15 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, the company's required return on stock, Rs and WACC are: Select one: a. 8%, 13.41% b. 5.25%, 13.41% c. 8.94%, 7.78% d. 7.94%, 11.55% e. 7.94%, 7.26%

Answer 1

Rs = [D1 / {P0 * (1 - Flotation Cost)}] + Growth Rate

= [$0.50 / {$20 * (1 - 0.15)}] + 0.05

= 0.0294 + 0.05 = 0.0794, or 7.94%

WACC = [Wd * Rd * (1 - t)] + [Ws * Rs]

= [0.25 * 8% * (1 - 0.35)] + [0.75 * 7.94%]

= 1.30% + 5.96% = 7.26%

Hence, Option "e" is correct.