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CFA Level 1 Question of the Week - Corporate Finance

Matt_AnalystPrepMatt_AnalystPrep MontrealPosts: 141 Associate
edited April 2017 in Level 1 Questions
An analyst gathered the following information about Altrian Corporation:

Before-tax cost of new debt: 7% 
Corporate tax rate: 30% 
Target debt-to-equity ratio: 0.7 
Current stock price: $55 
Next year's expected dividend: $4.5 
Estimated growth rate: 6%

The company's weighted average cost of capital (WACC) is closest to:

CFA Level 1 Question of the Week - Corporate Finance 5 votes

A. 10.36%
40% 2 votes
B. 8.40%
20% 1 vote
C. 12.44%
40% 2 votes

Comments

  • Matt_AnalystPrepMatt_AnalystPrep MontrealPosts: 141 Associate
    edited April 2017
    The correct answer is A.

    Cost of Equity = D1/P0 + g = 4.5/55 + 0.06 = 0.1418

    D/(D+E) = 0.7/1.7 = 0.4117

    WACC = wd * rd * (1-t) + wp * rp
    WACC = 0.4117 * 0.07 * (1-0.3) + (1-0.4117) * 0.1418 = 0.1036 or 10.36%

    Where

    wd = the proportion of debt that a company uses whenever it raises new funds

    rd = the before-tax marginal cost of debt

    t = the company’s marginal tax rate

    wp = the proportion of preferred stock that the company uses when it raises new funds

    rp = the marginal cost of preferred stock

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