The Weighted Average Cost of Capital (WACC) is calculated using the following formula:

$\text{WACC} = \left( \frac{E}{V} \cdot r_e \right) + \left( \frac{D}{V} \cdot r_d \cdot (1 - T) \right)$

Where:

• $E$: Value of equity
• $D$: Value of debt
• $V = E + D$: Total value of the firm
• $r_e$: Cost of equity
• $r_d$: Before-tax cost of debt
• $T$: Corporate tax rate

Step 1: Identify given values

• $E/V = 60\% = 0.6$ (Proportion of equity)
• $D/V = 40\% = 0.4$ (Proportion of debt)
• $r_d = 5\% = 0.05$ (Before-tax cost of debt)
• $T = 20\% = 0.2$ (Corporate tax rate)
• Current dividend $D_1 = 1.00$ (Dividend one year from now)
• Stock price $P_0 = 25$
• Dividend growth rate $g = 4\% = 0.04$

Step 2: Calculate the cost of equity ($r_e$)

Using the Gordon Growth Model: $r_e = \frac{D_1}{P_0} + g$

$r_e = \frac{1.00}{25} + 0.04 = 0.04 + 0.04 = 0.08 = 8\%$

Step 3: Substitute values into the WACC formula

$\text{WACC} = \left( \frac{E}{V} \cdot r_e \right) + \left( \frac{D}{V} \cdot r_d \cdot (1 - T) \right)$

$\text{WACC} = \left( 0.6 \cdot 0.08 \right) + \left( 0.4 \cdot 0.05 \cdot (1 - 0.2) \right)$

$\text{WACC} = 0.048 + 0.016 = 0.064 = 6.4\%$

Final Answer:

The Weighted Average Cost of Capital (WACC) for Earth Enterprises is 6.4%.

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Would you like further details or an explanation of any step?
Here are 5 related questions to expand your understanding:

1. How does the WACC change if the proportion of debt financing increases?
2. What is the significance of the corporate tax rate in WACC calculations?
3. How is the cost of equity derived when dividends are not growing at a constant rate?
4. Can WACC be used to evaluate projects with different risk profiles?
5. What are the limitations of the Gordon Growth Model in estimating $r_e$?

Tip: Always ensure that the WACC is applied to projects or investments with comparable risk levels to the firm's existing operations.