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 companys 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 periods 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%

4. Hiro Corp. common stock is selling for $29.50 per share. The last dividend was $2.40 and dividends are expected to grow at an 8% annual rate. Flotation costs on new stock sales are 11% of the selling price. What is the cost of Hiro Inc.'s new commonstock?