Cup Cake Ltd. has 20 million shares of stock outstanding selling at $25 per share and an issue of $30 million in 8 percent, annual coupon bonds with a maturity of 16 years, selling at 98 percent of par ($1,000). If Cup Cake's weighted average tax rate is 34 percent, its next dividend is expected to be $2.00 per share, and all future dividends are expected to grow at 4 percent per year, indefinitely, what is its WACC?

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of equity using the dividend growth model:
Next dividend = $2.00 per share
Dividend growth rate = 4%
Cost of equity (rs) = (Next dividend / Current stock price) + dividend growth rate
= ($2.00 / $25) + 4%
= 12%
Step 2: Calculate the after-tax cost of debt:
Coupon rate = 8%
Market price = 98% of $1,000 = $980
Annual interest payment = Coupon rate x Par value = 8% x $1,000 = $80
Tax rate = 34%
After-tax cost of debt (rd) = Coupon rate x (1 - Tax rate)
= 8% x (1- 34%)
= 5.28%
Step 3: Calculate the weight of equity:
Weight of equity (we) = (Number of shares x Current stock price) / (Total financing)
= (20 million x $25) / ($500 million + $30 million)
= 74.07%
Step 4: Calculate the weight of debt:
Weight of debt (wd) = (Debt market value) / (Total financing)
= $30 million / ($500 million + $30 million)
= 5.66%
Step 5: Calculate the WACC using the formula:
WACC = (we x rs) + (wd x rd) x (1 - Tax rate)
= (74.07% x 12%) + (5.66% x 5.28%) x (1 - 34%)
= 11.64%
Therefore, the WACC of Cup Cake Ltd. is 11.64% which is represented by choice letter C.