Purpose of Assignment
Students should understand corporate risk and be able to use the financial models learned in the class to evaluate and calculate a company’s weighted average cost of capital and use the analysis to make company investment decisions.
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Scenario: Wilson Corporation (not real) has a targeted capital structure of 40% long term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year’s dividend is $2.50 per share that is growing by 4% per year.
Prepare a minimum 700-word analysis including the following:
Calculate the company’s weighted average cost of capital. Use the dividend discount model. Show calculations in Microsoft® Word.
The company’s CEO has stated if the company increases the amount of long term debt so the capital structure will be 60% debt and 40% equity, this will lower its WACC. Explain and defend why you agree or disagree. Report how would you advise the CEO.
Format your paper consistent with APA guidelines.
Example Re Week 4 Indiv
Scenario: Acme Co. has a targeted capital structure of 30% long term debt and 70% common stock. The debt is yielding 5% and the corporate tax rate is 32%. The common stock is trading at $40 per share and next year’s dividend is $3.25 per share that is growing by 3% per year.
Calculate the company’s weighted average cost of capital. Use the dividend discount model.
If the company increases the amount of long term debt so the capital structure will be 55% debt and 45% equity, will this increase or lower its WACC? Explain and advise the company as to how it should proceed.
Calculating The Weighted Average Cost of Capital (WACC)
Target Capital Structure (Weights) Before-Tax Cost Tax Rate After Tax Cost* Weighted After-Tax Cost**
Common stock 70.0% 11.1% 11.1% 7.79%
Debt 30.0% 5.0% 32.0% 3.4% 1.02%
Total 100.0% 8.81% WACC 8.81%
*For debt use (1-Tax Rate) x Before-tax cost
**Cap structure weight x After-tax cost. Sum all to get WACC
Calculate cost of common equity
Use Dividend discount model:
Calculating cost of common equity using the dividend discount model.
Basic formula P0 = D1 / (R-g)
If we rearrange the above to solve for R, we get:
R = (D1 / P0) + g
P0 $ 40.00
D1 $ 3.25
D1 / P0 8.1%
R = (D1 / P0) + g = 11.1% This is the cost of common equity.
Calculate cost of debt
Calculate the before tax cost of debt (or use amount given if appropriate).
In this problem it is stated that “The debt is yielding 5%” so use that value as the before tax cost of debt.