You are in charge of finding financing for a $5M project for your company. You h

Question

You are in charge of finding financing for a $5M project for your company. You have chosen the following scenario:

Issue 50,000 shares of common stock that is expected to pay a dividend of $1.70. They expect growth of 4% forever after and they will have a price of $50.00.

Issue 1,500 coupon bonds that have a YTM of 6.89%. The bonds will have maturities of 20 years and face value of $1,000. They will sell initially at the $1,000 face value.

Borrow the rest in private debt from a bank at a rate of 9.4%.

The firm’s tax rate is 35%. What is the project’s WACC?

Now, suppose the bank backs out and you have to instead replace that amount with more of the common stock. The confounding issue is that this changes the growth rate on the common stock to 5% and the YTM on the bonds to 7.25%. The tax rate remains at 35%. Given all this, what is the new WACC?

Explanation / Answer

PART I

Ke = (D1/P0)+g

= (1.7/50)+4%

= 0.034+0.04 = 0.074

Ke=7.4%

Kd (Bonds) = 6.89%

Kd (debt from banks) = 9.4%

Ke = 7.4%

Equity Fund         = 2,500,000

Bonds                             = 1,500,000

Debt from banks =   1,000,000

Total                    = 5,000,000

WACC = (2,500,000/5,000,000)(7.4%)+(1,500,000/5,000,000)(6.89%)(1-35%) +(1,000,000/5,000,000)(9.4%)(1-35%)

=0.5(7.4%)+0.3(6.89%)(1-35%)+0.2(9.4%)(1-35%)

=6.27%

PART II

Ke = (D1/P0)+g

= (1.7/50)+5%

= 0.034+0.05 = 0.084

Ke=8.4%

Kd (Bonds) = 7.25%

Ke = 8.4%

Equity Fund         = 3,500,000

Bonds                             = 1,500,000

Total                    = 5,000,000

WACC = (3,500,000/5,000,000)(8.4%)+(1,500,000/5,000,000)(7.25%)(1-35%)

=0.7(8.4%)+0.3(7.25%)(1-35%)

=7.29%

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