Avido Inc. is expected to pay a $2.00 dividend at year end (D1 = $2.00), the dividend is expected to grow at a constant rate of 4.50% a year, and the common stock currently sells for $47.00 a share. The before-tax cost of debt is 6.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings? 5.98% 6.57% 7.22% 6.91% 5.77%

6.57%

Explanation:

Given that,

D1 = $2.00

Dividend growth rate, g = 4.50%

Stock price, P0 = $47

Before-tax cost of debt = 6.50%

Tax rate = 40%

Target capital structure for Debt = 45%

Target capital structure for Common equity = 55%

Cost of equity:

= (D1 ÷ P0) + g

= ($2.00 ÷ $47) + 4.50%

= 4.25% + 4.50%

= 8.75%

After tax cost of dept:

= Before tax cost of dept × (1 - Tax rate)

= 6.50% × (1 - 0.40)

= 6.50% × 0.60

= 3.9%

Company’s WACC if all the equity used is from retained earnings:

= (Cost of equity × Percent of common equity) + (After tax cost of dept × Percent of debt)

= (8.75% × 55%) + (3.9% × 45%)

= 4.8125% + 1.755%

= 6.57%

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