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Brouse Systems Inc pays a $ 4 current dividend (D 0 = $ 4), the dividend is expected to grow at a constant rate of 6% a year, and the common stock currently sells for $ 48 per share
Brouse Systems Inc pays a $ 4 current dividend (D 0 = $ 4), the dividend is expected to grow at a constant rate of 6% a year, and the common stock currently sells for $ 48 per share. The before-tax cost of debt is 10%, and the tax rate is 20%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings? How the company's WACC will change if financial manager uses the following data for the estimation of the dividend growth rate: ROE = 18%, dividend payout ratio = 46%
Expert Solution
HI
As per DDM
Share Price = D0*(1+g)/(r-g)
48 = 4*(1+6%)/(r-6%)
48r - 2.88= 4.24
r = 14.83%
hence cost of equity = 14.83%
WACC = cost of debt*(1-tax rate)*debt% + Cost of equity*equity%
= 10*(1-0.2)*0.45 + 14.83*0.55
= 3.6 + 8.16
=11.76%
in the second scenario, growth rate g = ROE*(1-payout )
=18*(1-0.46)
=9.72%
So new cost of equity = (D0*(1+g) + Share price*g)/Share Price
= (4*(1+9.72%)+48*9.72%)/48
=9.0544/48
=18.86%
new WACC = cost of debt*(1-tax rate)*debt% + Cost of equity*equity%
= 10*(1-0.2)*0.45 + 18.86*0.55
= 3.6 + 10.37
=13.97%
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