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2 February, 20:54

Columbia Gas Company's (CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%. Select one: a ... a. 10.9% b. c. 19.6% c. b. 13.6% d. d. 16.9%

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  1. 2 February, 21:01
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    Current dividend per share paid (Do)

    = Total dividend

    No of shares outstanding

    = $1,600,000

    1,000,000 shares

    = $1.60 per share

    Current market price = $31

    Growth rate = 8% = 0.08

    Ke = Do (1 + g) + g

    Po

    Ke = $1.60 (1 + 0.08) + 0.08

    $31

    Ke = 0.1357 = 13.57%

    Interest rate on borrowing (Kd) = 10%

    Tax rate (T) = 40% = 0.40

    WACC = Ke (E/V) + Kd (D/V) (1-T)

    WACC = 13.57 (65/100) + 10 (35/100) (1 - 0.4)

    WACC = 8.82 + 2.10

    WACC = 10.9%

    The correct answer is A

    Explanation:

    In this case, we need to calculate cost of equity. The cost of debt has been given, which is the interest rate on long-term borrowing (10%). Since the debt proportion in the capital structure is 35% and equity proportion is 65%, it implies that the value of the firm is 100%. Then, WACC is the aggregate of cost of each stock and the proportion of each stock in the capital structure.
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