Sorensen Systems Inc.is expected to pay a $2.50 dividend at year end (D₁ = $2.50),the dividend is expected to grow at a constant rate of 5.50% a year,and the common stock currently sells for $87.50 a share.The before-tax cost of debt is 7.50%,and the tax rate is 25%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from retained earnings? Do not round your intermediate calculations.

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Quizplus · Accepted Answer

The company's Weighted Average Cost of Capital (WACC) can be calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of equity, D is the market value of debt, V is the total market value (E + D), Re is the cost of equity, Rd is the before-tax cost of debt, and Tc is the corporate tax rate. The cost of equity (Re) can be calculated using the Gordon Growth Model: Re = (D1 / P0) + g, where D1 is the dividend next year, P0 is the current price, and g is the growth rate. Plugging in the given values: Re = ($2.50 * 1.055) / $87.50 + 0.055 = 0.0829 or 8.29%. The after-tax cost of debt is Rd * (1 - Tc) = 7.50% * (1 - 0.25) = 5.625%. Using the target capital structure to calculate WACC: WACC = (0.55 * 8.29%) + (0.45 * 5.625%) = 4.5595% + 2.53125% = 7.09075%, which rounds to 7.13%.