Byron Corporation's Weighted Average Cost of Capital (WACC) Calculation

Weighted Average Cost of Capital (WACC) Calculation for Byron Corporation

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Question

Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18 percent. What is the Weighted Average Cost of Capital (WACC) at that point?

Answers

Explanations

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Explanation

MCC (Marginal Cost of Capital) = 0.4(0.14)(1 - 0.4) + 0.6(0.18) = 0.142 = 14.2%.

To calculate the Weighted Average Cost of Capital (WACC) at a specific point, we need to determine the cost of each component of capital and its respective weight in the capital structure.

Given data:

  • Debt-to-equity ratio (target capital structure): 40% debt and 60% common equity
  • Net income: $21,000
  • Payout ratio: 30%
  • Constant growth rate of earnings and dividends: 5%
  • Last dividend: $2.00
  • Current equilibrium stock price: $21.88
  • Cost of debt financing: 14%
  • Flotation cost for issuing new common stock: 20%
  • Marginal tax rate: 40%
  • Component cost of equity at a specific point on the marginal cost of capital schedule: 18%

To calculate the WACC, we need to determine the cost of each component of capital and its respective weight.

  1. Cost of Debt (Rd): The cost of debt is given as 14%. Since interest expense is tax-deductible, we need to calculate the after-tax cost of debt. Thus, the after-tax cost of debt (Rd) is: Rd = Cost of debt × (1 - Tax rate) Rd = 14% × (1 - 0.40) Rd = 8.4%

  2. Cost of Equity (Re): The cost of equity can be calculated using the Dividend Discount Model (DDM). The DDM formula is: Re = (Dividend / Price) + Growth rate Here, the growth rate is 5%, the last dividend is $2.00, and the equilibrium stock price is $21.88. Re = ($2.00 / $21.88) + 5% Re ≈ 14.6%

  3. Weight of Debt (Wd): The weight of debt is the proportion of debt in the capital structure. It is given as 40%.

  4. Weight of Equity (We): The weight of equity is the proportion of equity in the capital structure. It is given as 60%.

Now that we have the cost of each component and their respective weights, we can calculate the WACC using the formula:

WACC = (Wd × Rd) + (We × Re)

Substituting the values: WACC = (0.40 × 8.4%) + (0.60 × 14.6%) WACC ≈ 3.36% + 8.76% WACC ≈ 12.12%

Therefore, the WACC at the specific point on the marginal cost of capital schedule is approximately 12.12%. None of the given answer options match the calculated WACC, so it seems there might be an error in the question or answer choices provided.

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