Schadler Systems is expected to pay a $3.50 dividend at year-end (D1 = $3.50), the dividend is expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company's WACC if all equity is from retained earnings?

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of equity using the dividend growth model:

Ke = (D1 / P0) + g
Ke = ($3.50 / $62.50) + 6.50%
Ke = 12.50%

Step 2: Calculate the after-tax cost of debt:

Kd = 7.50% * (1 - 0.40)
Kd = 4.50%

Step 3: Calculate the weighted average cost of capital (WACC):

WACC = (E/V * Ke) + (D/V * Kd * (1 - T))
E/V = 60%
D/V = 40%
T = 40%
WACC = (0.6 * 12.50%) + (0.4 * 4.50% * (1 - 0.40))
WACC = 9.06%

Schadler Systems Is Expected to Pay a $3