Question

has a target capital structure of 50% debt and 50% common equity. Davola funds debt by issuing 20-year, 8.6% semi-annual coupon bonds that currently sell for $900. Davola Inc. expects to pay a $1.75 dividend at the end of this year, its expected constant growth rate is 5%, and its common stock sells for $25. Their tax rate is 25%. 1. What is Davola’s component cost of debt? 2. What is Davola’s component cost of equity? 3. What Davoloa’s WACC?

Answer 1

Cost of debt after tax is 7.3%

cost of equity is 12.35%

WACC is 9.83%

Step-by-step explanation:

The cost of debt can be computed using the rate formula in excel.

The rate formula=rate(nper,pmt,-pv,fv)

the nper is the number of coupon payments the bond would make over its entire bond life i.e 20 years*2=40

pmt is the semiannual coupon=$1000*8.6%/2=$43

pv is the current price of $900

fv is the face value of $1000

=rate(40,43,-900,1000)=4.87%

yield =4.87%*2=9.74%

after tax cost=9.74%*(1-tax rate)=9.74%*(1-0.25%)=7.3%

The cost of equity:

share price=D*(1+g)/r-g

D is the dividend expected

g is the dividend growth rate

r is the cost of equity

r=(D*(1+g)/share price)+g

r=($1.75*(1+5%)/$25)+5%=12.35%

WACC=Ke*E/V+Kd*D/V

Ke is the cost of equity of 12.35%

E is 50% or 0.5

D is 50% or 0.5

V=0.5+0.5=1

Kd(after tax) =7.3%

WACC=(12.35%*0.5/1)+(7.3%*0.5/1)=9.83%