QUESTION THREE

1. The following information has been collected from the books of Billick Brother company:

• Capital structure consisting of 40% debt and 60% equity
• The company has 20year bonds outstanding at 9% annual coupon that are trading at par
• The company tax rate is 40%
• The risk free rate is 5.5%
• The market risk premium is 5%
• The stock's beta is 1.4

Required: Estimate the weighted average cost of capital

1. Suppose X Ltd is expected to pay $2 cash dividend at the end of the year. The required rate of return of the stock of X Ltd is 15%. If the share of X Ltd is currently selling at $40, what is the expected growth rate in the dividends of X Ltd. (5 marks)
2. The cost of capital is 15% and the before tax cost of debt is 9%. The market value of debt is $50 million and the market value of equity is $50 million. Given that the marginal income tax rate is 40%, calculate the cost of equity. (5 marks)
3. D Ltd.'s optimal capital structure is; debt: 25%, preferred stock 15%, common stock 60%. D Ltd.'s expected net income for the year is $35,000. It has established a dividend payout ratio is 30%, the corporate tax is 40%, the investors expect the future earnings and dividends to grow at a constant rate of 9%. D Ltd paid a dividend of $3 per share last year and its stock is currently selling for $40 per share. D Ltd can obtain new capital as follows;

New preferred stock with a dividend of $11 per share can be sold for $95 per share. Debt can be sold at an interest rate of 12%.

Calculate the Weighted Average Cost of Capital (WACC). (10 marks)