The management of Clay Industries have adhered to the following capital structure: 50% debt, 35% common equity, and 15% perpetual preferred equity. The following information applies to the firm:
Before-tax cost of debt = 9.5%
Combined state/federal tax rate = 35%
Expected return on the market = 14.5%
Annual risk-free rate of return = 6.25%
Historical Beta coefficient of Clay Industries Common Stock = 1.24
Annual preferred dividend = $1.55
Preferred stock net offering price = $24.50
Expected annual common dividend = $0.80
Common stock price = $30.90 -
Expected growth rate = 9.75%
Given this information, and using the Dividend-Yield-plus-Growth-Rate approach to calculate the component cost of common equity, what is the Weighted
Average Cost of Capital for Clay Industries?
Click on the arrows to vote for the correct answer
A. B. C. D. E. F.C
The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the
Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Dividend-Yield-plus-Growth-Rate, or
Discounted Cash Flow, approach. To calculate the cost of common equity using this approach, divide the expected annual dividend by the selling price of the outstanding common stock, and add the expected growth rate. Using the DCF method, the cost of common equity can be found as follows: {[$0.80/$30.90] +
9.75%} = 12.34%. The after-tax cost of debt can be found by multiplying the yield to maturity of the firm's outstanding long-term debt (9.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 6.175%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 6.327%. Incorporating these figures into the WACC equation gives the answer of 8.355%.