Question

Sally Gross, an investment analyst, has collected the following information regarding Lehman & Tiffany Co.:

--The yield to maturity (YTM) on the company's bonds is 10 percent.

--The company's current dividend is $0.80 a share.

--The company's stock price is $22.

--The company expects that its dividend will grow at a constant rate of 8 percent a year.

--The company's capital structure is 65 percent equity and 35percent debt. The company's tax rate is 40%.

--The company anticipates that total flotation costs will equal 11 percent of the amount issued.

Assume the company accounts for flotation costs. Calculate the company's WACC

Answer 1

The after-tax cost of debt

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 10.00% x (1 – 0.40)

= 10.00% x 0.60

= 6.00%

Cost of Equity

Here, we’ve current year dividend (D0) = $0.80 per share

Current Share Price (P0) = $22.00 per share

Dividend Growth Rate (g) = 8.00% per year

Flotation Cost (FC) = 11.00%

Therefore, the Cost of Equity (Ke) = [D0(1 + g) / {P0(1 - FC)}] + g

= [0.80(1 + 0.08) / {$22.00(1 – 0.11)}] + 0.08

= [0.8640 / {$22.00 x 0.89)}] + 0.08

= [0.8640 / $19.58] + 0.08

= 0.0441 + 0.08

= 0.1241 or

= 12.41%

Company’s Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [6.00% x 0.35] + [12.41% x 0.65]

= 2.10% + 8.07%

= 10.17%

“Hence, the Company’s Weighted Average Cost of Capital (WACC) will be 10.17%”