The current market price of the company’s share is $5; its next expected dividend is $0.20 and its expected growth rate is 10%. Flotation cost is 20% of the market price of the share.
3. What is the weighted average cost of capital
To calculate the weighted average cost of capital (WACC), you need to consider the cost of each component of capital and the weightage of each component in the company's capital structure. Here are the steps to calculate the WACC:
Step 1: Calculate the cost of debt:
If the company has issued debt, you need to calculate the cost of debt. However, the given information does not include any debt-related details. Therefore, assuming the company does not have any debt, the cost of debt is considered as zero.
Step 2: Calculate the cost of equity:
The cost of equity can be estimated using the dividend discount model (DDM) or capital asset pricing model (CAPM). Since the information given includes the expected dividend and growth rate, we can use the DDM approach.
Dividend Discount Model (DDM) formula:
Cost of Equity = (Next Expected Dividend / Current Market Price) + Expected Growth Rate
In this case:
Next Expected Dividend = $0.20
Current Market Price = $5
Expected Growth Rate = 10%
Cost of Equity = (0.20 / 5) + 0.10
= 0.04 + 0.10
= 0.14 or 14%
Step 3: Calculate the weightage of equity:
The weightage of equity depends on the proportion of equity in the company's capital structure. However, the given information does not provide any details about the capital structure. Therefore, we assume that the entire capital structure consists of equity. Hence, the weightage of equity is 100%.
Step 4: Calculate the flotation cost:
Flotation cost is given as 20% of the market price of the share. Therefore, the flotation cost is 20% of $5, which is $1.
Step 5: Calculate the weighted average cost of capital (WACC):
WACC = (Cost of Equity * Weightage of Equity) + (Cost of Debt * Weightage of Debt)
Since there is no debt, the WACC will only consist of the cost of equity. Thus, we can calculate the WACC as follows:
WACC = (Cost of Equity * Weightage of Equity)
= (0.14 * 1)
= 0.14 or 14%
Therefore, the weighted average cost of capital (WACC) for the company is 14%.