6. Calculate the company's weighted average cost of capital (WACC) under the following assumptions provided by Sue.

The company's long-term bonds currently offer a yield to maturity of 8 percent.

The company's stock price is $50 per share (P0 = $50).

The company recently paid a dividend of $2 per share (D0 = $2.00).

The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).

The company's target capital structure is 75 percent equity and 25 percent debt.

The company's tax rate is 40 percent.

How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?

Concept Check:

The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is computing the effect of the capital structure on expected returns by investors.

WACC = (E/V) x r_e + (D/V) x Rd x (1-Tc)

Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:

1. Risk is deviation from expectations.
2. We need to set expectations for our investments in relation to risk and return. Higher risk = higher return.
3. Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.
4. We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).
5. If cost of capital of the projects we undertake to increase sales rises then our risk rises and the return to our investors is reduced.
6. If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.
7. If risk increases or returns decrease our beta will increase to show the increase in risk this will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return.