16. The following tabulation gives earnings per share figures for the Foust Company during the preceding 10 years. The firm’s common stock, 7.8 million shares outstanding is now selling for $68 per share, and the expected dividend at the end of the current year is 50% of the 2003 EPS. Because investors expected past trends to continue, g may be based on the earnings growth rate.
Year EPS Year EPS
1993 $3.99 1998 5.73
1994 4.21 1999 6.19
1995 4.55 2000 6.68
1996 4.91 2001 7.22
1997 5.31 2002 7.80
The current interest rate of new debt is 11 percent. The firm’s marginal tax rate is 40 percent. Its capital structure, consider to be optimal, is as follows:
Debt $156,000,000
Common equity 104,000,000
Total liabilities and equity 260,000,000
a. Calculate Foust’s after tax cost of new debt and common equity. Calculate the cost of equity ks.
b. Find Foust’s WACC.
To calculate Foust's after-tax cost of new debt, we need to use the formula:
Cost of Debt = Interest Rate × (1 - Tax Rate)
Given that the current interest rate of new debt is 11% and the marginal tax rate is 40%, the calculation would be:
Cost of Debt = 11% × (1 - 40%) = 11% × 60% = 6.6%
Therefore, Foust's after-tax cost of new debt is 6.6%.
To calculate Foust's cost of equity, we can use the Dividend Discount Model (DDM) formula:
ks = (Dividend / Stock Price) + g
Where:
- ks is the cost of equity
- Dividend is the dividend per share
- Stock Price is the current selling price per share
- g is the expected growth rate of earnings per share
We can find the expected dividend for the current year by multiplying the 2003 EPS by 50%:
Expected Dividend = 50% × EPS for 2003 = 0.5 × 7.80 = 3.90
Now we can calculate the cost of equity (ks):
ks = (3.90 / 68) + g
To find the growth rate (g), we can use the compound annual growth rate (CAGR) formula:
CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) - 1
Using the EPS values for 1993 and 2002, we can calculate the growth rate over the 10-year period:
CAGR = (7.80 / 3.99)^(1 / 9) - 1 = 1.95 - 1 = 0.95
Therefore, the growth rate (g) is 0.95.
Now we can calculate the cost of equity (ks):
ks = (3.90 / 68) + 0.95
Next, to find Foust's Weighted Average Cost of Capital (WACC), we need to use the following formula:
WACC = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity)
To calculate the weight of debt, divide the debt value by the total liabilities and equity:
Weight of Debt = Debt / (Debt + Common Equity) = 156,000,000 / 260,000,000 = 0.60
To calculate the weight of equity, divide the common equity value by the total liabilities and equity:
Weight of Equity = Common Equity / (Debt + Common Equity) = 104,000,000 / 260,000,000 = 0.40
Now we can calculate Foust's WACC:
WACC = (0.60 × 6.6%) + (0.40 × ks)
Substitute the value of ks calculated earlier into the formula and solve for WACC.