Question

The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansio?n Calculate the Cost of bonds. Calculate the Cost of equity. Calculate the WACC

Answer 1

Step-by-step explanation:

First, find the pretax cost of debt (rd). Using a financial calculator, input the following;

N =25 , PV = -804 , PMT = 7%*1000 = 70, FV = 1,000,

then CPT I/Y = 9% (this is the pretax cost of debt)

Next, use Dividend discount model (DDM) to find cost of equity(re);

re = (D1/ Price) + g

re = (2/40) + 0.06

re = 0.11 or 11%

Use D/E ratio to find weight of debt(wD) and equity (wE);

If D/E = 0.8/1

and D+E = V (total capital value) = 0.8 +1 = 1.8

then wD = 0.8/1.8 = 0.4444

and wE = 0.5556

WACC = wE*re + wD*rd (1-tax)

WACC = (0.5556*0.11) + [0.4444*0.09(1-0.40) ]

= 0.0611 + 0.0240

= 0.0851

WACC is therefore = 8.51%