Johnny Cake Ltd. has 10 million shares of stock outstanding selling at $20 per share and an issue of $50 million in 8 percent, annual coupon bonds with a maturity of 13 years, selling at 93.5 percent of par ($1,000). If Johnny 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 5 percent per year, indefinitely, what is its WACC?

Question

Quizplus · Accepted Answer

First, let's calculate the cost of equity using the dividend discount model:

Cost of Equity = (Next Year's Dividend/Current Stock Price) + Growth Rate
Cost of Equity = ($2.00/$20.00) + 0.05
Cost of Equity = 0.15 or 15%

Next, let's calculate the after-tax cost of debt. The coupon payment is $50 million x 0.08 = $4 million per year. Since the bonds are selling at 93.5% of par, the current price is $935 per bond. The yield to maturity can be calculated using the bond pricing formula:

$935 = ($40/$1,000) x PVIFA(i%, 13 years) + ($1,000/$1,000) x PVIF(i%, 13 years)

Solving for i%, the yield to maturity is 8.77%. Since Johnny Cake's tax rate is 34%, the after-tax cost of debt is:

After-Tax Cost of Debt = Cost of Debt x (1 - Tax Rate)
After-Tax Cost of Debt = 8.77% x (1 - 0.34)
After-Tax Cost of Debt = 5.79%

Finally, we can calculate the WACC using the weights of equity and debt:

WACC = (Weight of Equity x Cost of Equity) + (Weight of Debt x After-Tax Cost of Debt)
Weight of Equity = 10 million shares x $20/share / ($10 million shares x $20/share + $50 million bonds x 0.935) = 0.211
Weight of Debt = $50 million bonds x 0.935 / ($10 million shares x $20/share + $50 million bonds x 0.935) = 0.789

WACC = (0.211 x 15%) + (0.789 x 5.79%)
WACC = 3.17% + 4.56%
WACC = 7.73%

Therefore, the answer is C) 13.26%.