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LAC Company expects to distribute $2.275 as dividends in the coming year.

Its expected
constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per
share. New stock can be sold to the public at the current price, but a flotation cost of 5% would
be incurred. What is the cost of equity from retained earnings using the DCF approach? And
what is the cost of equity raised by selling new common stock?
Answer:
Cost of equity from retained earnings:
rs = 2.275/32.5 + 0.06 = 13%
Cost of equity raised by selling new common stock:
re = 2.275/[32.5(1-0.05)] + 0.06 = 13.37%
Suppose Firm FM does not need to issue new stocks to finance its investment budget. What is
the firms WACC?
Given target capital structure is 30% debt (rd = 10%), 10% preferred stock (rp = 11%), and
60% equity (rs = 14%, re=15.4%), and tax rate = 40%.
WACC
= 0.3*10%*(1-0.4) + 0.1*11% + 0.6*14%
= 11.3%
Common mistakes that students make, would be applying the tax adjustment, i.e., (1 - T), to every cost
component or completely forgetting to tax-adjust.
Suppose firm FM does not have enough retained earnings to finance its investment budget and
needs to raise new common equity by issuing new stock. What is the firms WACC at the new
level of financing?
Given target capital structure is 30% debt (rd = 10%), 10% preferred stock (rp = 11%), and
60% equity (rs = 14%, re=15.4%), and tax rate = 40%.
WACC
= 0.3*10%*(1-0.4) + 0.1*11% + 0.6*15.4%
= 12.14%
Explanation:
In this question, we use the cost of new common stock only.
We do not use a weighted average of the cost of retained earnings and new common stock. The reason
being that we are calculating the WACC at the new level of financing. The WACC will vary depending
on the investment budget. As the volume of financing increases due to increasing investment projects,
the costs of various types of financing will increase, raising the WACC. For example,
o
o

When retained earnings is not enough, we will need to issue new common stock which is
more expensive.
Issuing more debt increases the default risk of the firm and this will also cause the cost
of debt to increase.

Therefore, it is useful to calculate a weighted marginal cost of capital, which is the WACC associated
with the next dollar of total new financing.

Using the tools you have picked up in the first few lectures, determine whether you should take
up the project below.
The initial investment for the project is $10,000 today. The project is expected to provide cash
flows of $4,000 at the end of the next three years, starting at t = 1. The risk-adjusted WACC is
10%.
Should this project be taken up?
First method
We can treat the project as a financial asset that cost -$10,000 today with expected cash flows of
$4,000 at the end of the next 3 years.
We can then find the annual returns associated with investing in the project,
i.e., 10000 = 4000/(1+r) + 4000/(1+r)2 + 4000/(1+r)3
r = 9.7%.
Since the expected returns is less than the WACC, we should not take up the project.
Second method
Find what is the PV of the stream of future cash flow discounted at WACC of 10%,
i.e., PV = 4000/(1+0.1) + 4000/(1+0.1)2 + 4000/(1+0.1)3 = 9947.41.
This project is only worth $9,947 as of today but requires $10,000 investment today.
Therefore, $10,000 investment is too much; the project should not be taken up.