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Question: Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 25%. What will be the WACC for this project? (Note: Round your intermediate calculations to two decimal places.)
To calculate the weighted average cost of capital (WACC), you need to determine the costs of the different financing components: equity, and in this case, new equity. The cost of new equity (ke) can be calculated using the Gordon Growth Model: ke = D1/P0 +g Where, D1 = the dividend expected to be paid out at the end of the period, which is $2.78 P0 = the current price of the stock, which is $33.35 g = the growth rate of the dividends, which is 9.2% or 0.092 ke = $2.78 / $33.35 + 0.092 ke = 0.08345 (or 8.345%) However, considering the flotation costs, we should adjust the price of the new stock: P0 = P0 * (1- Flotation cost %) P0 = $33.35 * (1 - 0.03) P0 = $32.35 So the cost of new equity (ke) considering flotation cost will be: ke = $2.78 / $32.35 + 0.092 ke = 0.08592 (or 8.592%) In this case where a firm is fully equity financed, the WACC is equivalent to the cost of new equity which is 8.592%. But keep in mind, these calculations do not include any debts or preferred stocks the firm might have. In a more comprehensive calculation, we'd need that information to take into account the costs of different financing sources. Also, no tax benefit from debt is included here due to the absence of debt in the capital structure. If there was, the formula for WACC would be a little more complex involving tax rates and weights of both debt and equity.
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