Assume that you are on the financial staff of Michelson Inc.,and you have collected the following data:- The yield on the company's outstanding bonds is 8.00%,and its tax rate is 40%.- The next expected dividend is $0.65 a share,and the dividend is expected to grow at a constant rate of 6.00% a year.- The price of Michelson's stock is $17.50 per share,and the flotation cost for selling new shares is F = 10%.- The target capital structure is 45% debt and the balance is common equity.What is Michelson's WACC,assuming it must issue new stock to finance its capital budget?

Question

Quizplus · Accepted Answer

1. Calculate the cost of equity:
The current dividend per share (D0) = $0.65
The expected growth rate (g) = 6%
The current market price per share (P0) = $17.50
So the cost of equity (Ke) can be calculated using the Gordon growth model:

Ke = (D1/P0) + g
   = ($0.65 × 1.06)/$17.50 + 0.06
   = 0.0994 or 9.94%

2. Calculate the cost of debt:
The yield on the company's outstanding bonds = 8%
The tax rate (T) = 40%
So the after-tax cost of debt (Kd) can be calculated as follows:

Kd = Yield to maturity × (1 - T)
   = 8% × (1 - 0.4)
   = 4.8%

3. Calculate the weights of debt and equity:
The target capital structure for Michelson is 45% debt and 55% equity. Therefore, the weights of debt (Wd) and equity (We) can be calculated as follows:

Wd = 0.45
We = 0.55

4. Calculate the cost of capital (WACC):
The weighted average cost of capital (WACC) can now be calculated using the following formula:

WACC = Wd × Kd × (1 - F) + We × Ke
     = 0.45 × 4.8% × (1 - 0.1) + 0.55 × 9.94%
     = 7.73%

Therefore, Michelson's WACC is 7.73%, which is closest to option D (7.73%).

Assume That You Are on the Financial Staff of Michelson