Sample Problem and Solution

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 per share. The before-tax cost of debt is 7.50% and the tax rate is 40.00%. The target capital structure consists of 40.00% debt and 60.00% common equity. What is the company's WACC if all equity is from retained earnings?

Solution:

1. (i)Describe the assumptions related to the problem:
2. The problem assumes the dividends of the company will grow at 6.50% forever and next periods dividend will be $3.50; a tax rate of 40.00% is also assumed for the firm.
3. (ii)Apply the appropriate mathematical model:
4. The cost of equity is based on the dividend growth model: