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15.1 Calculating the Cost of Equity Suppose stock in Watta Corporation has a beta of .80. The market risk premium is 6 percent, and the risk-free rate is 6 per- cent. Watta’s last dividend was $1.20 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $45 per share. What is Watta’s cost of equity capital? 15.2 Calculating the WACC In addition to the information given in the previous problem, suppose Watta has a target debt-equity ratio of 50 percent. Its cost of debt is 9 percent, before taxes. If the tax rate is 35 percent, what is the WACC? 15.3 Flotation Costs Suppose in the previous problem Watta is seeking $30 million for a new project. The necessary funds will have to be raised externally. Watta’s flotation costs for selling debt and equity are 2 percent and 16 percent, respec- tively. If flotation costs are considered, what is the true cost of the new project? 15.1 We start off with the SML approach. Based on the information given, the ex- pected return on Watta’s common stock is: R E ± R f ²³ E ´ ( R M µ R f ) ± 6% ² .80 ´ 6% ± 10.80% We now use the dividend growth model. The projected dividend is D 0 ´ (1 ² g ) ± $1.20 ´ 1.08 ± $1.296, so the expected return using this approach is: R E ± D 1 / P 0 ² g ± $1.296/45 ² .08 ± 10.88% Because these two estimates, 10.80 percent and 10.88 percent, are fairly close, we will average them. Watta’s cost of equity is approximately 10.84 percent. 15.2 Because the target debt-equity ratio is .50, Watta uses $.50 in debt for every $1 in equity. In other words, Watta’s target capital structure is 1/3 debt and 2/3 eq- uity. The WACC is thus: WACC ± ( E / V ) ´ R E ² ( D / V ) ´ (1 µ T C ) ± 2/3 ´ 10.84% ² 1/3 ´ 9% ´ (1 µ .35) ± 9.177%% 15.3 Because Watta uses both debt and equity to finance its operations, we first need the weighted average flotation cost. As in the previous problem, the percentage of equity financing is 2/3, so the weighted average cost is: f A ± ( E / V ) ´ f E ² ( D / V ) ´ f D ± 2/3 ´ 16% ² 1/3 ´ 2% ± 11.33% If Watta needs $30 million after flotation costs, then the true cost of the project is $30 million/(1 µ f A ) ± $30 million/.8867 ± $33.83 million. Answers to Chapter Review and Self-Test Problems Chapter Review and Self-Test Problems CHAPTER 15 Cost of Capital 517
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1. WACC On the most basic level, if a firm’s WACC is 12 percent, what does this mean? 2. Book Values versus Market Values In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why? 3. Project Risk If you can borrow all the money you need for a project at 6 per- cent, doesn’t it follow that 6 percent is your cost of capital for the project? 4. WACC and Taxes Why do we use an aftertax figure for cost of debt but not for cost of equity? 5.
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