The WACC is used as the discount rate to evaluate various capital budgeting proj

Question

The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If its current tax rate is 40%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. 0.77% 0.54% 0.74% 0.64% Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 8.7%, $20,000 of preferred stock at a cost of 9.9%, and $320,000 of equity at a cost of 13.2%. The firm faces a tax rate of 40%. What will be the WACC for this project?

Explanation / Answer

Solution for question 1

Before tax Cost of debt = 8.2%

Tax rate = 40%

After tax cost of debt = 8.20% × (1 – 40%)

                                   = 4.92%

Cost of debt is 4.92%

Cost of preferred stock = 9.3%

Cost of equity if it is finance through retained earnings = 12.4%

Weight of debt in capital structure = 58%

Weight of equity in capital structure = 36%

Weight of preferred stock in capital structure = 6%

Now calculate WACC for company is calculated below:

WACC = 58% × 4.92% + 36% ×12.40% + 6% × 9.30%

             = 2.85% + 4.48% + 0.56%

             = 7.88%

WACC of company if equity is finance through retained earnings is 7.88%.

Again if equity is finance through external source

Then cost of equity = 14.20%

Now calculate WACC for company is calculated below:

WACC = 58% × 4.92% + 36% ×14.20% + 6% × 9.30%

             = 2.85% + 5.12% + 0.56%

             = 8.52%

WACC of company if equity is finance through external source is 8.52%.

Excess percentage of WACC = 8.52% - 7.88%

                                                  = 0.64%

Excess percentage of WACC if it is finance through external source is 0.64%.

Hence, option (D) is correct answer.

Solution for Question 2

Total value of capital required = $570,000

Value of debt in capital Stricture = $230,000

Value of equity in capital Stricture = $320,000

Value of preferred stock in capital Stricture = $20,000

So

Weight of debt in capital structure = 40.35%

Weight of equity in capital structure = 56.14%

Weight of preferred stock in capital structure = 5.51%

Before tax Cost of debt = 8.7%

Tax rate = 40%

After tax cost of debt = 8.70% × (1 – 40%)

                                   = 5.22%

Cost of debt is 5.22%

Cost of preferred stock = 9.9%

Cost of equity = 13.2%

Now calculate WACC for company is calculated below:

WACC = 40.35% × 5.22% + 56.14% ×13.20% + 5.51% × 9.90%

             = 2.11% + 7.41% + 0.55%

             = 10.07%

WACC for the project is 10.07%.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.