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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

WACC AND PERCENTAGE OF DEBT FINANCING Hook Industries’s capital structure consists solely of debt and common equity. It can issue debt at rd = 11%, and its common stock currently pays a $2.00 dividend per share (D0 =$2.00). The stock’s price is currently $24.75, its dividend is expected to grow at a constant rate of 7% per year, its tax rate is 35%, and its WACC is 13.95%. What percentage of the company's capital structure consists of debt?

Summary Introduction

To determine: The percentage of the company’s capital structure consists of debt.

Introduction:

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the sources through which the firm finances its capital. It is the rate that a company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is calculated by taking the relative weight of each item of capital structure.

Formula to calculate the WACC is,

WACC=Wdrd(1t)+WPrp+Wcrs

Where,

  • Wd is the weight of the debt.
  • WP is the weight of the preferred stock.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rP is cost of the preferred stock.
  • rc is the cost of the equity.
Explanation

Given information:

WACC is 13.95%.

Cost of debt is 11%

Cost of equity is 15.65% (working note).

Tax rate is 35%.

The company does not have any preferred stock. The formula to calculate WACC is,

WACC=Wdrd(1t)+Wcrs

Where,

  • Wd is the weight of the debt.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rc is the cost of the equity.
  • t is tax rate.

Substitute, 0.1395 for WACC, 0.1565 for rc 0.11 for rd and 0.35 for t

0.1395=Wd×0.11(10.35)+(1Wd)0.15650.1395=0.0715 Wd+0.15650.1565 Wd0.1565 Wd0.0715 Wd=0.15650

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