WACC Estimation On January 1, the total market value of the Tysseland Company wa
ID: 2759979 • Letter: W
Question
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 $25 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that 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 10% 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 $1.20/$30 = 4%.) The marginal corporate tax rate is 35%.
a.In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Enter your answer in dollars. For example, $1.2 million should be entered as $1200000. $
b.Assuming there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity, what is its WACC? Round your answer to two decimal places. %
Explanation / Answer
(a) Total investment in new project = $ 25,000,000
Weight of equity = Total equity / Total debt
Weight of equity = 30,000,000 / 60,000,000 = 0.50
New investment financed by common equity = 0.50 x 25,000,000 = $ 12,500,000
(b) Step1: Computation of cost of equity.We have,
Price of stock = D1 / (Ke -g)
30 = 1.2 / (Ke - 0.08)
Ke - 0.08 = 0.04
Ke = 0.04 + 0.08 = 0.12*100 = 12%
Hence, the cost of equity is 12%.
Step2: Computation of cost of debt after tax.We have,
Cost of debt after tax = Cost of debt x (1-tax rate)
Cost of debt after tax = 10% x (1 - 0.35) = 6.50%
Step3: Computation of the WACC.We have,
WACC = (Weight of equity x Cost of equity) + ( Weight of debt x cost of debt after tax)
WACC = (0.50 X 0.12) + ( 0.50 X 0.0650)
WACC = 0.06 + 0.0325 = 0.0925*100 = 9.25%
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