Carson’s ribs, inc. has hired you to calculate its wacc. • debt: it currently issues 10-year bonds with an annual coupon of 5.5%. its bonds sell for $1,075.00 and has a par value of $1,000.000. • equity: common stock sells for $45.00 per share and it paid a $1.00 annual dividend, last year. if the company were to sell new common stock, it would incur a flotation of 5% of the price paid by investors. • the growth rate of earnings is 10%. if its target capital structure is 30% debt and 70% common equity, find the wacc for carson’s ribs. assume a tax rate of 25%

WACC =9.902%

Explanation:

Lets first understand what WACC is. WACC or weighted average cost of capital represents the total cost of financing. Now there are two main sources of long-term finance available to an entity, DEBT and EQUITY. Each source of finance has a different cost which highly depends upon the RISK PROFILE and RISK APPETITE of an entity. Some entities prefer debt financing over equity while some consider equity as more reliable source of finance.

When an entity takes finance from each source, it finds itself with a pool of funds which are then allocated based on priorities. WACC is the cost of the 'POOL OF FUNDS' (i.e an average cost of both debt and equity).

The formula of WACC is as follows:

WACC= ke×(E/V) + kd×(d/V)

ke= cost of equity

E= market value of equity

V= combined value of debt and equity

kd= cost of debt

So in order to find WACC we need to first calculate Ke and Kd.

Cost of equity can be calculated using the formula mentioned below.

ke= {d(1+g) ÷ p×(1-0.05)} + g

ke= cost of equity

d= dividend per share

g= growth rate

p= market price per share

ke= {$1(1.1) ÷ $45×( 1-0.05)} + 0.1

ke=  12.5%

Cost of Debt can be calculated using the formula below.

kd= i×(1-t)÷p

i= interest (5.5%×%1000=$55)

t= tax

p= market value of debt

kd= $55×(1-0.25)÷1075

kd= 3.84%

NOTE: (SINCE WE DON'T HAVE ENOUGH INFORMATION IN ORDER TO CALCULATE TOTAL MARKET VALUES OF DEBT AND EQUITY, WE CAN USE THE TARGET CAPITAL STRUCTURE TO COMPUTE WACC)

WACC = (12.5%×70÷100) + (3.84%×30÷100)

WACC= 8.75%+ 1.152%

WACC =9.902%

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