What is company WACC if all equity is from retained earnings

Assignment Help Financial Management
Reference no: EM131893186

Instructions:

You are required to use a financial calculator or spreadsheet (Excel) to solve 10 problems (provided on page 3) related to the cost of capital. You are required to show the following 3 steps for each problem (sample questions and solutions are provided for guidance):

(i) Describe and interpret the assumptions related to the problem.

(ii) Apply the appropriate mathematical model to solve the problem.

(iii) Calculate the correct solution to the problem.

Sample Questions and Solutions

Sample Question:

A company is expected to pay a $3.50 dividend at year-end, the dividends are expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?

Solution

(i) The problem assumes the stock will have a constant growth of 6.5% forever. The constant growth model is appropriate to use for this problem. The accuracy of the solution depends on the correctness of the constant growth assumption.

The cost of equity assumes there will not be any new stock issuance. Therefore, the cost of equity is the cost of retained earnings for the existing shareholders.

The cost of debt should be on after-tax basis due to the tax shield provided by the interest expense.

(ii) The cost of equity is based on the following: Kre = (D1/P0) + g P0 is the current price to be calculated,

D1 is the next period’s dividend,

R is the required return on this stock

• g is the constant growth

The cost of debt is based on kd = rd(1-T)

rd is the before-tax cost of debt

T is the tax rate

The WACC is based on: WACC = wdkd + wrekre

(iii) Cost of retained earnings = (3.5/62.5) + 0.065 = 0.121 or 12.1% Cost of debt = 7.5 x (1-0.4) = 4.5%

WACC = (0.4x4.5) + (0.6x12.1) = 9.06%

The average cost of capital for this company based on their existing debt and equity is 9.06%

Question that need to be answer are:

1. ABC Corp. is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be $50 per bond. The marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?

2. New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60 every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be 4%. If the firm has a 35% marginal tax bracket, what is cost of existing debt?

Please if you answer correctly with the explanation.

Reference no: EM131893186

Questions Cloud

Company must charge per unit to breakeven on investment : Tristan's Toys invested in a new manufacturing system. What is the minimum price that the company must charge per unit to breakeven on the investment?
Mutual fund that tracks the broad market index : A year ago today, you invested $30,000 in a mutual fund that tracks the broad market index. How many additional shares did you purchase with your distributions?
Response to expected run-up in stock market : Assume that you are about to select a specific stock that will perform well in response to an expected run-up in the stock market.
Calculate dividend payout ratio and retention ratio : Calculate dividend payout ratio and retention ratio for your chosen company.
What is company WACC if all equity is from retained earnings : The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?
The before-tax cost of debt-after tax cost of debt : The before-tax cost of debt is_____ the after tax cost of debt.
Beta for each stock based on the actual observations : Calculate the beta for each stock based on the actual observations?
What is the total cash flow in year six of this project : Hollister & Hollister is considering a new project. What is the total cash flow in year 6 of this project?
What was the time of the loan : If he paid back a $6,800 loan with $20 interest at 7.5%, what was the time of the loan?

Reviews

Write a Review

Financial Management Questions & Answers

  Foreign company acquisition

Acquisition by a foreign company and the effects of that decision and the results of foreign exchange in Euro and the exchange rate differences.

  Financial management for profit and non profit organizations

In this essay, we are going to discuss the issues of financial management in a non-profit organisation.

  Method for estimating a venture''s value

Evaluate venture's present value, cash and surplus cash and basic venture capital.

  Replacement analysis

This document show the Replacement Analysis of modling machine. Is replacement give profit to company or not?

  Business finance task - capital budgeting

Your company is considering using the payback period for capital-budgeting. Discuss the advantages and disadvantages of this technique.

  Analysis of the investment

In this project, you will focus on one of these: the additional cost resulting from the purchase of an apple press (a piece of equipment required to manufacture apple juice).

  Conduct a what-if analysis

Review the readings and media for this unit, including the Anthony's Orchard case study media. Familiarise yourself with the Anthony's Orchard company and its current situation.

  Determine operational expenditures

Organisations' behaviour is guided by financial data. In the short term, such data will help determine operational expenditures; in the long term, historical data may help generate forecasts aimed at determining strategic plans. In both instances.

  Personal financial management

How much will you have left over each half year if you adopt the latter course of action?

  Sources of finance for expansion into new foreign markets

A quoted company is considering several long-term sources of finance for expansion into new foreign markets.

  Long term financial planning

This assignment is designed for analyze Long term financial planning begins with the sales forecast and the key input in the long term fincial planning.

  Explain the role of fincial manager

This assignment explain the role of fincial manager, function of manger. And what are the motives of financial manager.

Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd