Question

Lexington Corporation wants to maintain its capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments: Bonds: Bonds can be issued at a pre-tax cost of 7.1 percent. Bank loans can be issued at a pre-tax cost of 11.0 percent. Common Equity: Some retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $50. Flotation costs will be $3 per share. The recent common stock dividend was $7.34. Dividends are expected to grow at 7% in the future. What is the cost of capital using bonds and internal equity

Answer 1

15.5%

Step-by-step explanation:

WACC = weight of equity x cost of equity + weight of debt x cost of debt x (1 - tax rate)

Debt = 0.4 x 7.1% x (1 - 0.34) = 1.8744%

the cost of equity isn't given and it would have to be determined using the constant dividend growth model

the constant dividend growth model

price = d1 / (r - g)

d1 = next dividend to be paid

r = cost of equity

g = growth rate

50 = (7.34 x 1.07) / r - 0.07

r = 22.71%

equity = 0.6 x 22.71 = 13.62%

WACC = 13.62 + 1.87 = 15.49%