Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
-Refer to Byron Corporation.Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18.0 percent.What is the weighted average cost of capital at that point?

Question

Quizplus · Accepted Answer

We can use the WACC formula to calculate the weighted average cost of capital at the given point:

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)

where:

E = market value of equity
V = total market value of the firm (equity + debt)
Re = cost of equity
D = market value of debt
Rd = cost of debt
T = tax rate

First, we need to find the market value of equity and debt:

Market value of equity = current equilibrium stock price x number of shares outstanding
Market value of equity = $21.88 x N/A (number of shares outstanding is not given)

Next, we can use the target capital structure to find the market value of debt:

Market value of debt = total market value of the firm - market value of equity
Market value of debt = (0.4/0.6) x market value of equity
Market value of debt = 0.67 x market value of equity

Since Byron can raise all the debt financing it needs at 14.0 percent and the target capital structure is 40% debt, we can use 14.0% as the cost of debt (Rd).

Next, we need to find the cost of equity (Re) using the dividend growth model:

Re = (D1 / P0) + g

where:

D1 = expected dividend next year = D0 x (1 + g)
g = constant growth rate in dividends = 5%
P0 = equilibrium stock price = $21.88

D1 = $2.00 x (1 + 0.05) = $2.10
Re = ($2.10 / $21.88) + 0.05 = 0.145 or 14.5%

Finally, we can plug in the values and calculate the WACC:

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)
WACC = [(N/A)/(N/A + 0.67 x N/A)] x 0.145 + [0.67 x N/A /(N/A + 0.67 x N/A)] x 0.14 x (1 - 0.4)
WACC = 0.43 x 0.145 + 0.57 x 0.084
WACC = 0.06235 or 6.235%

Therefore, the weighted average cost of capital at the given point is 6.235%, which is closest to answer choice (C) 14.2%.

Byron Corporation Byron Corporation's Present Capital Structure, Which Is Also Its Target