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A company has determined that its optimal capital structure consists of 40% debt and 60% equity. Assume the firm will not have enough retained earnings to fund the equity portion of its capital budget, and the cost of capital is adjusted to account for flotation costs. Given the following information, calculate the firm's WACC. - rd = 8%. - Net income = $40,000. - Payout ratio = 50%. - Tax rate = 40%. - P0 = $25. - Growth = 0%. - Shares outstanding = 10,000. - Flotation cost on additional equity = 15%.

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Answer:

WACC = Ke(E/V) + Kd(D/V)(1-T)

WACC = 10.67(60/100) +  8(40/100)(1-0.4)

WACC = 6.402 + 1.92

WACC = 8.322%

Ke = Do/Po(1-FC)

Ke = 2/25(1-0.25)

Ke = 2/18.75

Ke = 0.1067 = 10.67%

Earnings per share = Net income/No of common stocks outstanding

Earnings per share = $40,000/10,000 shares

Earnings per share = $4

Dividend per share(Do) = 50% x $4

Dividend per share(Do) = $2

Explanation:

In this case, there is need to calculate earnings per share by dividing the net income by the number of common stocks outstanding. Since the dividend pay-out ratio is 50%, it implies that dividend per share will be 50% of earnings per share,

We also need to calculate cost of equity by dividing the dividend per share by the current market price after adjusting for floatation costs.

Finally, we will now compute the weighted average cost of capital, which is a function of cost of equity and the proportion of equity in the capital structure plus after-tax cost of debt and the proportion of debt in the capital structure.

The firm WACC is 7.60%.

  • The calculation is as follows:

Cost of equity = dividend ÷  price  

The dividend per share is

=  0.5 × 40,000 ÷10,000

= 2

Now

Cost of equity after floatation cost is

= 2 ÷ (25 × 0.85)

= 9.41%

Now  

WACC = 0.4 × 8 × 0.6 + 0.6 × 9.41

=  7.60%

Therefore we can conclude that the firm WACC is 7.60%.

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