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 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%. 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? 0.64% 0.54% 0.83% 0.86% Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 10.2%, $30,000 of preferred stock at a cost of 11.4%, and $140,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%. What will be the WACC for this project? Kuhn Co. is considering a new project that will require an initial investment of $45 million. It has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. Kuhn has noncallable bends outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company's current bends is a good approximation of the yield on any new bends that it issues. The company can sell shares of preferred stock that pay an annual dividend of $8 at a price of $95.70 per share. You can assume that Jordan does not incur any flotation costs when issuing debt and preferred stock. Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $1.36 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 40'%. Determine what Kuhn Company's WACC will be for this project.

Explanation / Answer

Answer: Case of Turnbull Co.

WACC will be higher by 0.64

=(14.2%-12.4%)*36%

=0.64

Answer: New WACC:

After tax cost of debt=10.2%(1-0.40)=6.12%

WACC=Wd*Kd+We*Ke+Wp*Kp

=(100000/270000)*6.12%+(140000/270000)*14.3%+(30000/270000)*11.4%

=2.27%+7.41%+1.27%

=10.95%

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