Alpha Products maintains a capital structure of 40% debt and 60% common equity. To finance its capital budget for next year, the firm will sell $50 million of 11% debentures at par and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha expects net income to grow 7% to $140 million, and dividends also are expected to increase 7% to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40%, what is its weighted cost of capital for the coming year?

Question

Quizplus · Accepted Answer

The weighted cost of capital (WACC) is calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc). Here, E/V = 60%, D/V = 40%, Re (cost of equity) can be estimated using the Gordon Growth Model: Re = (D1/P0) + g = (1.40/30) + 0.07 = 0.1167 or 11.67%. Rd (cost of debt) = 11%, and Tc (tax rate) = 40%. WACC = (0.60 * 0.1167) + (0.40 * 0.11 * (1 - 0.40)) = 0.07002 + 0.0264 = 0.09642 or 9.64%.

Alpha Products Maintains a Capital Structure of 40% Debt and 60