10-15 WACC Estimation : On January 1, the total market value of the Tysseland Co
ID: 2702087 • Letter: 1
Question
10-15 WACC Estimation: On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm%u2019s present market value capital structure, shown below, is considered to be optimal. There is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders required rate of return is estimated to be 12%, consisting of a dividend yield of 4%, and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 40%.
a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?
b. Assume there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.
Explanation / Answer
a. Equity is 50% of the total capital structure. If they want to retain the same, then amount financed by common equity = 30 million * 50% = $15 million
b. As bonds are at par, yield = coupon rate = 8%. After tax cost of equity = 8%*(1-tax rate) = 8%*(1-40%) = 4.8%.
WACC = 0.5*12% + 0.5*4.8% = 8.4%
c. If new shares are issued, then there is no impact on cost of equity or cost of debt. However, the capital structure changes - the debt value is the same, but the equity value is greater than before. So there is greater weightage to cost of equity than cost of debt (as compared to equal weightage of 50% now). As cost of equity is higher than the current WACC, this will lead to WACC increasing from 8.4% to a higher number.
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