Eureka Membership Warehouse, Inc., is a rapidly growing chain of retail outlets offering brand-name merchandise at discount prices. A security analyst’s report issued by a national brokerage firm indicates that debt yielding 13% composes 25% of Eureka’s overall capital structure. Furthermore, both earnings and dividends are expected to grow at a rate of 15% per year.
Currently, common stock in the company is priced at $30, and it should pay $1.50 per share in dividends during the coming year. This yield compares favorably with the 8% return currently available on risk-free securities and the 14% average for all common stocks, given the company’s estimated beta of 2.
A. Calculate Eureka’s component cost of equity using both the capital asset pricing model and the dividend yield plus expected growth model.
B. Assuming a 40% marginal federal-plus-state income tax rate, calculate Eureka’s weighted average cost of capital.